How I’d aim to build passive income with a £20k Stocks and Shares ISA

What’s my route to setting up a passive income for my old age? With reasonable caution, I see nothing I like better than UK shares.

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Seeking to build up an investment pot that pays passive income, I’d combine two of my favourite things. One is the UK stock market, which has beaten other forms of investment for more than a century.

Those planning to invest for less than a decade would face more risk than I’d be happy with. But it needs time and patience to build a solid second income, so I don’t see that as too much of a hardship.

Tax protection

My other favourite thing is a Stocks and Shares ISA. With one of those, we can invest up to £20k each year and not pay any tax when we finally take money out.

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Did you know there are more than 4,000 ISA millionaires in the UK? And not one of them will have to pay a single penny to the Inland Revenue on any of it.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Long-term plan

Diversification‘s a key part of my strategy. So I look for dividend-paying stocks in multiple sectors. I like banking and insurance. But I’m sure glad I didn’t have all my money in the finance sector when the 2008 banking collapse hit us. Or when Covid led to the banks suspending their dividends.

I’ll use one of my own investments here to illustrate how I’d aim for top passive income. The approach is straightforward and applies just as well to a diverse portfolio of dividend stocks.

Lloyds Banking Group (LSE: LLOY) has two key things I look for. Forecasts show rising dividends in the coming years, and they’d be well covered by earnings.

Banking favourite

I want my dividends to at least keep pace with inflation. And I’d never rely on dividends where I didn’t see the cash coming in to pay them.

The Lloyds share price has risen in 2024, dropping this year’s expected dividend yield to 4.8%.

Created with Highcharts 11.4.3Lloyds Banking Group Plc PriceZoom1M3M6MYTD1Y5Y10YALL6 Apr 20203 Apr 2025Zoom ▾Jul '20Jan '21Jul '21Jan '22Jul '22Jan '23Jul '23Jan '24Jul '24Jan '25202120212022202220232023202420242025202520406080www.fool.co.uk

But forecasts show it up to about 6% by 2026. So let’s see how a 6% annual dividend, reinvested in more shares, could compound upwards over the long term.

A single £20k ISA allowance invested in Lloyds shares, with that annual return, could more than treble in 20 years, to £64,000, without ever putting more money in.

Alternatively, £5,000 every year for 20 years could grow to a whopping £190,000.

Lloyds faces uncertainty as interest rates fall and should cut into lending margins. And the finance sector still looks a bit shaky. So I expect short-term volatility. Individual investors need to decide if they’re happy with that.

Spread the cash

If I was starting again today, I’d go for investment trusts first. I bought some City of London Investment Trust shares. And that’s been paying dividends of around 4.5-5%.

It’s not the biggest yield. But it diversifies across Unilever, HSBC Holdings, Shell, Tesco… and more top UK stocks. And it’s raised its dividend for 58 years in a row.

I’d also consider Murray Income Trust (4.5% yield, raised for 51 straight years), and Merchants Trust (4.9%, 42 years).

I keep in mind that dividends are never guaranteed though. And that’s one more reason to diversify, even among investment trusts.

But here’s another bargain investment that looks absurdly dirt-cheap:

Like buying £1 for 31p

This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Alan Oscroft has positions in City Of London Investment Trust Plc and Lloyds Banking Group Plc. The Motley Fool UK has recommended HSBC Holdings, Lloyds Banking Group Plc, Tesco Plc, and Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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