An ISA can be a useful way not only to try and build long-term wealth but also to set up passive income streams.
Over time, that can add up to a substantial source of income.
That is down to two things: buying shares that go on to pay large dividends, and turbo-charging returns by reinvesting those dividends rather than taking them out as cash.
Income, income, income
This is not a scheme that will turn my ISA into an income goldmine overnight. I am a long-term investor and my approach to earning passive income reflects that.
I could happily wait for a decade before I switch from reinvesting the dividends (known as compounding) to taking them in cash. After 10 years compounding at 8% annually, I should be earning around £1,727 per year in passive income. That is roughly £33 a week.
Buying quality shares for their dividends
My 8% figure is based just on dividends. In reality, it could be boosted by share price growth, although the opposite might happen if the shares I buy fall in value.
I think an 8% dividend yield is achievable in the current market. Yes, it is more than double the FTSE 100 average. But a number of FTSE 100 shares I happily own offer a higher yield than that right now. One is Legal & General (LSE: LGEN).
Finding shares to buy
I do not start by looking at yield. After all, no dividend is guaranteed to last. It might go up but it can also go down, perhaps to zero.
So instead I look for great businesses with attractive share prices and only then consider their yields.
Legal & General appeals to me for a number of reasons. Its business is in the field of financial services, especially those linked to retirement such as pensions. That is a huge market and I think it is likely to remain that way. Legal & General has a large customer base and its established, well-known brand can help it win and retain clients for its products.
It has long experience in the financial services market. That has helped it hone a business model that in the past few years has been consistently profitable.
That does not mean that everything is plain sailing.
First-half profit after tax attributable to equity holders was 41% lower than in the prior year period. The company faces a number of challenges. It noted in its interim results that the global economic outlook remains uncertain, with “the potential for external shocks to knock economies and markets off course”.
Looking to the future
The company cut its dividend during the last financial crisis, so such economic volatility is a risk I am watching. Still, I happily own the shares and the current yield is 9.2%.
That is well above the 8% I mentioned above as a target.
If I had a spare £10,000 in a Stocks and Shares ISA I would happily buy Legal & General (and shares I found similarly attractive), to try and build towards my second-income target.
