Earning a second income in an ISA has become more critical than ever. Apart from higher inflation underscoring the need for multiple income streams, the latest tax hikes in the Autumn Budget are putting even more pressure on many households.
This is where dividends come to the rescue. While investing in the stock market isn’t risk-free, it does open the door to many potentially lucrative opportunities – many of which require minimal effort to exploit. And best of all, by using a Stocks and Shares ISA, all of it can be earned entirely tax-free.
With that in mind, let’s explore how investors can aim to transform a £20,000 ISA into a £12,000 tax-free passive 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.
Making a plan
On average, dividend-paying UK shares offer a yield close to 4%. That means investing £20,000 would unlock an £800 second income overnight.
It’s certainly a nice start, but it’s a far cry from the £12,000 target. That’s why, instead of taking these profits right away, it might be smarter to let them automatically reinvest, compounding the wealth-building process.
When combined with capital gains, UK shares have historically generated a total average annualised return close to 8%. And £20,000 left to compound at this rate for 34 years would grow into £300,000 – enough to unlock that £12,000 passive income at a 4% yield.
Of course, waiting around for over three decades isn’t a lot of fun. So let’s speed the process up with some small monthly top-ups.
By investing a further £250 each month, the timeline is slashed to just 22 years. Those able to contribute £500 each month would be able to reap the rewards in just over 17 years.
But we can still speed this up even further.
Picking winning investments
While the stock market might have generated an average return of 8%, there are plenty of investments that have vastly outperformed. And those who can identify these winners early can go on to build phenomenal levels of wealth.
Take Computacenter (LSE:CCC) as a prime example to consider.
Over the last 15 years, the IT services enterprise secured its critical position within the technology value chain for businesses looking to digitalise and modernise their operations. The result? Shareholders who reinvested their dividends have earned a 1,117% total return since December 2010.
That translates into an 18.1% average annualised return. And it’s enough to transform a £20,000 ISA into £300,000 with £250 monthly top-ups in just 12 years instead of 22.
Today, the business continues to enjoy strong momentum, particularly in North America, where hyperscalers continue to invest aggressively in AI infrastructure. As such, the firm’s order book continues to expand while free cash flow is on the rise, resulting in ever-increasing dividends and buybacks.
Of course, even with its strengths, Computacenter still has risks. The competitive landscape for IT sourcing is growing increasingly intense. And if macro uncertainties dampen customer demand, delays in IT spending could start to emerge, harming the group’s performance.
Nevertheless, with a stellar track record of navigating through both the peaks and troughs of the IT market cycle, Computacenter is definitely a stock I think is worth considering when building a second income portfolio. And it’s not the only enterprise I’ve got on my radar.
