There’s an undeniable appeal to the idea of earning a second income. For some, it means added financial security in case of tough times. For others, it’s about saving for a property or building a retirement cushion without relying solely on the State Pension.
One of the most tax-efficient ways for UK residents to aim for this goal is through a Stocks and Shares ISA. Any capital gains or dividends earned inside the ISA are free from tax. That means dividend stocks can be a particularly powerful tool, providing regular income without the taxman taking a slice.
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.
Dividend-paying companies distribute a portion of their profits directly to shareholders. For an investor, that means cash in the account, often paid quarterly.
The key however, is sustainability. Chasing the very highest yields can be risky – if a company over-extends itself, the dividend can be cut. Instead, it makes sense to focus on firms with consistent track records, manageable payout ratios and strong balance sheets.
What to look for in dividend stocks
One FTSE 100 dividend share worth considering is Imperial Brands (LSE: IMB). The company’s best known for its tobacco products but is steadily pivoting towards less harmful alternatives. Right now, the stock offers a generous 6% dividend yield and a payout ratio of 62.5%, which looks relatively sustainable.
In fact, it has managed to grow its dividend every year for the past four years.
Of course, there are concerns. Imperial carries around £10bn in debt compared with £5bn in equity, while free cash flow sits at just £2.5bn. Servicing that debt while investing in new product development could stretch its resources. If earnings were to slip, a dividend cut could be on the cards.
Still, there are positives. Imperial boasts a huge return on equity (ROE) of 54.4% and an operating margin of 20%. Those profitability levels give some reassurance that it has the firepower to keep rewarding shareholders, for now.
Other appealing dividend stocks include the property trust Land Securities Group, which offers a dividend yield of around 7% and a payout ratio of nearly 75%. Alternatively, insurance giant Phoenix Group has a 7.8% yield and 10 years of consecutive dividend growth.
Targeting a £12,000 second income
So how does an investor get from here to a meaningful second income? Let’s assume a diversified portfolio of dividend stocks with an average 7% yield. To generate a £12,000 annual income, the portfolio would need to be worth around £171,430.
That figure might sound daunting, but time and compounding make it far more achievable.
By investing just £150 a month in an ISA and reinvesting the dividends along the way, an investor could potentially build more than £170,000 within 20 years. From there, the dividends alone could provide the equivalent of £1,000 a month in tax-free second income.
Analysts may debate which stocks are best, but the principle remains clear. Dividend-paying shares held in an ISA can be a powerful way of building long-term wealth and generating a second income.
While individual stock risks always need to be weighed carefully – as the example of Imperial Brands shows – a diversified approach makes the target of £12,000 a year look far from unrealistic.
