Here’s how I’m trying to build up my ISA to earn £5,000 in passive income each month

Millions of Britons use their Stocks and Shares ISAs to build wealth and eventually draw a tax-free passive income. Dr James Fox explains how it works.

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When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

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The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

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For me, the very best way to earn a second income is by putting money in an ISA and following a well-trodden investment strategy in order build wealth. Of course, the more money an investor has, the easier it is to generate a large passive income.

Sadly, most Britons still elect to build wealth through savings accounts, which with annualised returns typically below 3%, that money isn’t growing very quickly.

Stock markets typically perform better than savings

Investing in stock markets typically yields significantly higher returns compared to traditional savings accounts. Many individuals, particularly beginners, opt for index-tracking funds, which aim to replicate the performance of major market indexes. Historical data underscores the long-term growth potential of such investments.

For instance, the FTSE 100 has delivered an average annual return of 6.3% over the past 20 years, with the FTSE 250 outperforming its large-cap counterpart. In the US, the S&P 500‘s averaged an impressive 10.5% annually since its inception in 1957, climbing to an even higher average of 13.3% in the decade leading up to 2024. Similarly, the Nasdaq posted an exceptional 19.8% average return over the past decade.

These figures starkly contrast with the comparatively modest interest rates offered by savings accounts, emphasising the advantage of stock market investments for building wealth over the long term.

Doing the maths

Personally, I prefer to pick individual stocks, trusts and specific funds, over index-tracking funds. That’s because I believe I can beat the market — after all, researching stocks is essentially what I do.

However, if an investor had chosen a tracker of any of the above major indexes over the last decade, they would have vastly surpassed the returns they could have achieved in a savings account. Let’s assume an investor puts £500 a month into an index tracker. Here’s how that money could perform in an S&P 500 tracker, based on the previously noted historical growth rates (but note, past performance is no guarantee of future success).

Thecalculatorsite.com

Why did I use the S&P 500 data? Well, because it quite conveniently works out to just over £1.2m over 30 years. Putting that money in stocks with an average dividend yield of 5% would generate £5,000 of monthly passive income — and tax-free. This is what I’m aiming to do, but by cherry-picking stocks, I’m hoping to grow my money faster.

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.

One to consider for the growth phase

While index trackers are a great way to start investing, investors may want to consider an exciting growth-oriented trust like Edinburgh Worldwide Investment Trust (LSE:EWI). It’s a Baillie Gifford-run fund — like the well-known Scottish Mortgage Investment Trust — and it’s a really interesting, albeit risky proposition. The fund aims to invest initially in entrepreneurial companies when they’re still nascent.

The trust’s largest investment is SpaceX, which represents a significant 12.3% of the portfolio. This is followed by PsiQuantum at 7.5% and Alnylam Pharmaceuticals. These are fairly high-risk investments, but given supportive trends in artificial intelligence (AI), space exploration, and even quantum computing, this could be the right time to take a diversified approach to emerging technologies.

However, some of its holdings aren’t publicly listed, and only listed companies are required to disclose earnings reports, which means crucial data on these private entities is scarce, heightening uncertainty for investors.

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.

James Fox has positions in Edinburgh Worldwide Investment Trust and Scottish Mortgage Investment Trust Plc. The Motley Fool UK has no position in any of the shares mentioned. 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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