Stuffing a Stocks and Shares ISA full of dividend shares is one way to try and build a sizeable second income.
That can be a lucrative approach and doesn’t involve the time and effort of taking on a second job.
How does it work in practice? Let’s get into it.
How dividends can mean income
The amount of income an ISA earns depends basically on two factors – how much is invested and at what dividend yield.
Dividend yield is the annual income expressed as a percentage of the cost of the shares.
So, for example, a dividend yield of 10% on a £20k ISA would mean an annual second income of £2k. A 5% yield on the same amount would generate £1k each year in dividends.
10% is an unusually high dividend yield. The FTSE 100 index of leading blue-chip companies is yielding 3.3% at the moment.
Still, I think a 7% target yield is possible in today’s market by carefully selecting a portfolio of blue-chip shares.
Taking the long-term approach
A 7% yield on £20k would mean a £1,400 second income per year.
But what if someone wanted to earn more? Say £1k each month – that’s £12k a year.
At a 7% yield, that would require an ISA of close to £172k. Ah, I hear you say, but the ISA contribution allowance is £20k per year for most investors.
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That’s right – but I see this as a long-term approach.
By putting in £20k a year to an ISA and compounding (reinvesting the dividends) for a compound annual growth rate of 7%, someone could grow their ISA to that amount within six years.
Choosing the right shares
Compound annual growth can come from share price rises as well as dividends. But share prices can fall too – and no dividend’s ever guaranteed to last.
Therefore, it’s important to choose what shares to buy carefully. Like billionaire investor Warren Buffett, I try to stick to what I understand. I look for great businesses with attractive share prices.
The return’s not just about the share price and dividend by the way: ISA fees, commissions, and charges can eat into it too, especially over the long run.
So it makes sense for an investor to choose the best Stocks and Shares ISA for their own needs.
One share to consider
One of the shares I think investors seeking a second income should consider is FTSE 100 insurer Phoenix Group (LSE: PHNX).
With its 8% yield, the company is well ahead of the FTSE 100 average. But it still aims to grow its dividend per share each year. It has been doing that in recent years – but can it keep doing so in future?
With a huge customer base and powerful brands like Standard Life, Phoenix is a cash generation machine even though it may not be a household name itself. It has a deep understanding of the specialist pensions market and also benefits from economies of scale.
One risk I see is any sudden market correction leading to asset prices falling. That could hurt Phoenix’s asset base value and mean lower earnings.
Over time, though, I reckon the company’s got strong dividend prospects.
