Stuffing a Stocks and Shares ISA with income shares, then letting dividends earn dividends, is one way to try and build sizeable passive income streams.
When I talk about letting the dividends earn dividends, I am referring to what is sometimes known as compounding.
Rather than taking out dividends as cash, this involves reinvesting them to grow a larger capital base while sticking within the confines of the ISA contribution limit.
An ISA can be suitable for that because, typically, dividends inside it can be reinvested without affecting the contribution allowance but crucially, at the right point, they can also start to be withdrawn as tax-free passive income.
Such withdrawals are not always available within a given timeframe in all investment vehicles, as some of them effectively bar any withdrawals before a certain age.
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.
£3k a month, every month, in income
To bring that theory down to earth in a practical way, let me illustrate what I mean.
Suppose an investor starting with zero sets up a Stocks and Shares ISA then puts £450 each month into it and buys shares. If the returns compound at 8% annually, after 27 years it will be big enough that an 8% dividend yield would generate over £3k per month on average of passive income.
The compound annual growth rate (CAGR) is key for the first 27 years and it can be a blend of share price growth and dividends. However, falling share prices could eat into it — and dividends are never guaranteed.
After the 27 years, I am presuming an 8% average dividend yield.
In today’s market, I think an 8% CAGR is achievable even while sticking to proven blue-chip shares. But even the best-seeming share can disappoint. That helps explain why it is always important for an investor to stay diversified. With £450 a month going into the Stocks and Shares ISA – even before considering dividends – that ought to be easy.
A flexible approach
As this example illustrates, the amount of income possible down the line depends on how much is invested, what it earns and the timeframe involved.
So with a longer timeframe, a £3k monthly passive income could be realistic even from contributing less than £450 per month. By contrast, putting more in could speed up the process.
One share to consider
But it is important not to focus on a higher compound annual growth rate without assessing any risks involved. All shares carry risks and greed can be costly. Very high yields, for instance, are often unsustainable and a sign of a falling share price.
Sticking with the 8% CAGR target, one stock I think investors should consider is Legal & General (LSE: LGEN).
Currently the FTSE 100 financial services group offers a dividend yield of 8.3%. Its strong brand, large customer base and focus on the lucrative long-term market of retirement-linked products are all strengths, in my view.
The firm aims to grow its dividend per share by 2% annually. That is modest but – if it is achieved – is still growth. That is on top of an already high yield.
But the sale of a large US business could reduce future profits, while rocky markets may lead some policyholders to pull out funds, eating into earnings. Only time will tell whether Legal & General can maintain its lucrative dividend.
