Earning a chunky passive income with an ISA is a phenomenal way to achieve financial freedom. After all, with the income and capital gain tax burden reduced to zero, not only can investors build substantial wealth, but also reap the rewards without HMRC knocking on the door.
While there are several types of ISA to choose from, it’s the Stocks and Shares ISA that arguably has the most power. Yes, it comes with a bit of risk. But, don’t forget that over the long term, the stock market’s proven itself to be one of the most sustainable ways to build wealth easily, outpacing savings accounts and bonds.
So let’s say an investor wants to earn a £1,000 monthly passive income. Just how much do they need to invest?
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.
Crunching the numbers
A grand a month translates into £12,000 a year. And if we’re following the classic 4% withdrawal rule, that means a portfolio needs to be worth around £300,000 to supply this.
Obviously, that’s not pocket change and might make this seem like a fruitless endeavour. However, the good news is, even with only £500 to spare each month, most households can gradually build to this target over time, thanks to compounding returns.
When looking at the long-term performance of the FTSE 100, the UK stock market’s historically provided an average return of 8% a year. Investing £500 a month at this rate when starting from scratch would eventually reach the target £300,000 in around 20 years. That means even someone who’s just turned 40 should still have enough time to get the ball rolling for their retirement.
Speeding things up
Instead of just aiming to replicate the FTSE 100’s performance, investors can opt to analyse businesses and pick individual stocks for their portfolio. If done correctly, they’ll end up owning only the best companies, allowing their annualised return to jump, perhaps even double!
Take Halma (LSE:HLMA) as an example to consider. The company focuses on acquiring and improving industrial engineering businesses within the Safety, Environmental Monitoring, and Healthcare markets. Over the last 20 years, management’s focused on building and reinforcing its leadership in these niche but critical arenas. The result? Expanding profit margins have elevated earnings to new record highs every year since 2003.
Executing such a strategy hasn’t been risk-free. Acquisitions, even small ones, can backfire if they don’t live up to expectations. And Halma has made a few blunders along the way. But with leadership remaining exceptionally disciplined in capital allocation and maintaining a healthy balance sheet, the impact of these losers was far offset by the winners.
Subsequently since 2005, revenue’s grown from £300m to £2.3bn, with profits expanding from £45m to just shy of £300m. For loyal shareholders who reinvested dividends, that’s translated into an average annualised gain of 16.8%. And at this rate, the journey to £300,000 with £500 a month would slash almost seven years from the waiting time.
Obviously, not every stock has been as successful as Halma. And there are plenty of others that failed to even generate a positive return, let alone keep up with the FTSE 100. But it goes to show that by investigating diligently, it’s possible to uncover some game-changing winners.
