As inflation erodes spending power, many UK investors turn to dividend stocks to generate a second income. A diversified Stocks and Shares ISA can be a powerful tool to achieve this goal, especially considering the tax-free contribution limit of up to £20,000 annually.
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.
But is it possible to earn a meaningful second income through an ISA?
Yes — but it all depends on the amount invested and the average yield. To bring in a modest £2k a year, a £20k portfolio requires an unusually high yield of 10%. Dividends are never guaranteed and the higher the yield, the harder it is for a company to sustain it.
Realistically, a dedicated income-focused investor could aim for an average yield of around 7%. That would require a portfolio worth almost £30k to achieve £2k in annual dividends.
Fortunately, due to the miracle of compounding returns, this amount could be built up fairly quickly from £20k. In less than five years of reinvesting dividends, it would reach £30k.
At that point, the annual dividends would be £2k and continue growing exponentially each year.
Stocks to pick
An ISA should be diversified among growth, income and defensive stocks in various sectors and regions. This helps to maintain stable growth and protect against a downturn in one specific area.
However, to achieve a 7% average yield, high-yield dividend shares should be the focus.
In the UK, popular dividend stocks include M&G, Legal & General, British American Tobacco, ITV and Vodafone. These all have yields between 6% and 9%.
A second income from real estate
For reliable dividends, investors might consider a real estate investment trust (REIT) like Primary Health Properties (LSE: PHP). It specialises in the ownership and management of over 500 modern primary healthcare facilities across the UK and Ireland.
These long-term, government-backed rental agreements make it one of the most defensive REITs on the London Stock Exchange. It’s a popular choice among income investors due to its long track record, with no cuts or reductions in over 20 years.
Currently with a yield around 7%, dividends have been growing at an average annual rate of 4%.
Risks and considerations
Like many REITs, Primary Health is sensitive to interest rates, a factor contributing to a 35% price drop in the past five years.
As borrowing costs rise, debt becomes more expensive and can limit its earnings. Even with most of its debt fixed, higher refinancing costs could put pressure on margins. It also has low dividend cover, which means a sudden drop in earnings could threaten future payments.
When considering investment trusts, it’s important to compare the price to the net asset value (NAV). This reveals whether the trust is trading for more or less than everything it owns. Primary Health typically trades at a premium to NAV, reflecting its income reliability. However, since 2022, it has occasionally dipped below NAV due to market-wide fears about interest rates and property valuations.
Currently, it trades at a modest discount to NAV, making it relatively attractive for long-term income seekers.
This is just one example of a reliable income stock that could be consider to benefit a second income portfolio. It’s best practice to build a diverse portfolio of 10 to 20 stocks, balancing out growth and stability.
