Earning a tax-free passive income in the UK is exceptionally easy, thanks to the power of ISAs.
Both Cash ISAs and Stocks and Shares ISAs allow savers and investors to build wealth. And after enough compounding, it’s possible to start earning a substantial second income.
So let’s say I want to earn an extra £500 each month without having to work for it. How much do I need to have in my ISA?
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.
Saving vs investing
Some top-notch Cash ISAs currently offer around 4% interest on savings today. So if the goal’s £500 a month, or £6,000 a year, that would require a nest egg worth £150,000.
For a Stocks and Shares ISA, the amount needed might be roughly the same. That’s because it just so happens that UK dividend shares historically have yielded close to 4% on average as well.
So now the question becomes, how do I get the £150k needed to unlock this tax-free income stream?
This is where a Stocks and Shares ISA has a massive advantage. Even when investing in boring FTSE 100 large-cap companies, these have typically generated a total return closer to 8% a year – double that of Cash ISAs today. And with more interest rate cuts on the horizon, the returns of the stock market only become even more attractive.
Let’s say I’m starting from scratch today and I drip feed £500 a month into a Cash ISA. Assuming the interest rate doesn’t change, it will take around 18 years to reach the £150,000 target threshold. By comparison, for a Stocks and Shares ISA earning 8% a year, this timeline is slashed by roughly five years.
But investors can potentially do even better…
Aiming for bigger returns
Rather than relying on an index fund, stock picking allows investors to own only the best and brightest businesses. And investors who used this strategy to spot the opportunity with Anglo American (LSE:AAL) 10 years ago are laughing today.
The once-struggling diversified mining group has delivered staggering returns since 2016, following an operational turnaround supported by rising commodity prices, particularly for iron and copper. As such, investors who bought shares towards the beginning of the company’s turnaround have gone on to earn a 2,020% total return.
That’s the equivalent of a 35.7% annualised gain! And at this explosive rate, anyone who’s been investing £500 each month over the last decade is now sitting on a staggering £549,823 – enough to generate a passive income of £1,833 a month!
With copper demand still rising rapidly to support the electrification of global infrastructure, Anglo American continues to benefit from commodity-driven tailwinds. And with some non-core divestments being executed to raise capital, management’s also enjoying a lot more financial flexibility to execute its long-term strategy.
Of course, commodity prices don’t go up forever. And with other mining groups seeking to capitalise on rising copper prices, there’s a risk of market oversupply, which would drag prices down. Similarly, divestments come with execution risk that can disrupt cash flow if mishandled.
In short, unlike saving, investing comes with considerably more risk. But with the potential for outsized returns, these risks are sometimes worth taking. And for those seeking to get started today, Anglo American shares could be worth a closer look.
