How could an investor use £20,000, an ISA, and 5 dividend shares to target annual income of £3,225?

There are plenty of dividend shares around at the moment. I reckon 83 stocks on the FTSE 350 are presently offering yields in excess of 5%.

Impressively, if this level of return could be achieved by an investor for 25 consecutive years, an initial investment of £20,000 would grow to £67,727. And after a quarter of a century, the portfolio would generate income of £3,225 a year, or £269 a month. Not bad for doing very little.

I chose £20,000 as a lump sum in my example because this is the maximum amount that can be invested each year in a Stocks and Shares ISA.

The principal advantage of this type of investment vehicle is that all gains and income are earned tax-free.

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However, it must be pointed out that dividends are never guaranteed. And any investment can go down in value, without warning.

Spreading the risk

That’s why diversification is important. Putting this hypothetical £20,000 into just one stock wouldn’t be a good idea.

Of course, an investor could be lucky and choose one that soars in value. But there’s also the possibility that they’d pick one that underperforms the wider market.

There are no hard and fast rules when it comes to choosing how many stocks to buy. But it’s a mathematical certainty that the more shares an investor has in their portfolio, the closer the return’s likely to be to the market average.

My approach

Personally, I think, with £20,000 available, that investing in five stocks makes sense.

And I’d target the many UK shares that have paid generous dividends for several years.

One of these is Legal & General (LSE:LGEN). Over the past 25 years, it has only ever cut its dividend during the 2007-2008 financial crisis. For 2024, it’s promised to pay 21.36p a share, which is a 5% increase on 2023. This means the stock’s presently yielding a rather impressive 9.2%.

And the company has pledged to increase its payout by 2% a year, from 2025 to 2027.

The stock remains on my watchlist for when I next have some spare cash. That’s because I think the company is well positioned to maintain its strong payout, and continue to grow it over time.

The group currently has a pipeline of £14bn of third-party pension schemes that it’s looking to acquire. In 2023, it achieved a return on equity of 9.7%. Let’s say it manages to secure ‘only’ a third of these retirement plans and repeats its 2023 return — annual earnings would increase by at least £450m. For context, its adjusted operating profit in 2023 was £1.67bn.

Legal & General is also financially robust, holding more than twice the level of reserves that it’s legally obliged to have.

Other considerations

But there are risks. The company has £197bn of equities, and nearly £10bn of investment properties, on its balance sheet. Any stock market or property market wobbles are therefore likely to have a huge impact.

The company also faces stiff competition. This could explain why its assets under management fell by 2.9%, during the 12 months to 30 June 2024.

However, despite these potential challenges, I remain a fan of the stock. And I reckon it shouldn’t be too difficult to find another four UK shares — with above-average yields — that would complement Legal & General in a diversified and well-balanced portfolio.