Ordinarily, how much someone needs to invest to earn £15,000 a year in passive income depends on their tax bracket. But a Stocks and Shares ISA makes things much easier.
The ability to protect investments from dividend tax is a big asset for investors. And investors shouldn’t underestimate what that means in terms of a second income.
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 taxes
UK investors currently get a £500 annual dividend allowance. After that, the income they receive from companies is taxed at a rate that depends on their income bracket.
This can dramatically change the amount an investor needs to generate in dividends to make £15,000 a year. At different tax levels, the equation is as follows:
| Tax bracket | Dividend tax rate | Pre-tax dividends | Post-tax dividends |
|---|---|---|---|
| Basic rate | 8.75% | £16,390 | £15,000 |
| Higher rate | 33.75% | £22,376 | £15,000 |
| Additional rate | 39.35% | £24,408 | £15,000 |
A Stocks and Shares ISA, however, makes everything much more straightforward. An investor only needs a portfolio that generates £15,000 a year in dividends to keep that £15,000 a year.
This makes a big difference to the amount someone needs to invest to earn a £15,000-a-year second income. And this is especially true in the upper tax brackets.
High yields
Legal & General (LSE:LGEN) shares currently have the highest dividend yield in the FTSE 100. At 8.95%, that means a portfolio worth £167,597 could generate £15,000 a year.
High yields, however, often come with risks – and I think that’s the case here. The long-term nature of life insurance means companies can’t reset their pricing in response to rising costs.
The firm is also distributing more in dividends than it’s making in net income. While it’s very capable of funding this from its surplus cash in the short term, it’s not sustainable indefinitely.
A big dividend yield offsets a lot of this risk and an investment could turn out very well if inflation and bond prices are favourable. But I think investors should proceed with caution.
Competitive advantages
Not all insurance companies are the same, though, and I’m much more positive about Admiral (LSE:ADM) as an investment. Its 5.43% dividend yield is still well above the FTSE 100 average.
The firm focuses on car insurance, where contracts typically last a year instead of decades. So while inflation is still a risk, the company has the chance to reset its pricing every 12 months.
There are other risks – car insurance is a heavily regulated business where consumers are driven by low prices. But Admiral’s telematics operation gives it a big advantage over competitors.
This has manifested itself in underwriting margins that have consistently outperformed the wider industry. And this is a long-term strength that I think makes the stock worth considering.
How much do you need?
I like Admiral very much, as an investment. But I think passive income investors should look for opportunities to build a diversified portfolio.
A 5.43% yield means a basic rate taxpayer without an ISA would need £301,841 invested to earn £15,000 a year in dividends. And this rises to £412,081 at the higher rate and £449,502 in the additional rate bracket.
With an ISA, however, someone — in any tax bracket — only needs a portfolio worth £276,243. There aren’t many guarantees with dividends, but a Stocks and Shares ISA might be the nearest thing income investors have to a no-brainer.
