With an increasing number of providers, using a Stocks and Shares ISA to earn a second income is now easier than ever. And with the government cutting the amount that can be invested each year in a Cash ISA, now could be an ideal time for savers with a bit left over each month to consider investing in the stock market.
Here’s one possible approach.
Keep on buying
My preferred method of earning passive income is to buy stocks that have a solid track record of paying above-average dividends. But instead of spending the money received on something non-essential, I reinvest the cash to buy yet more shares. Of course, there can never be any guarantees when it comes to investing but, if all goes to plan, the dividends received should increase each year.
This technique’s known as compounding. And by adopting this approach for several years – supplemented by a small monthly investment — it could be transformational. Let’s take a look at some examples.
A few numbers to ponder
The table below shows how much an ISA would be worth after investing £100 a month for either 20, 25 or 30 years, at various rates of return.
| Years/Return | 5% | 6% | 7% | 8% |
|---|---|---|---|---|
| 20 | £40,745 | £45,564 | £51,040 | £57,266 |
| 25 | £58,812 | £67,958 | £78,746 | £91,483 |
| 30 | £81,869 | £97,925 | £117,606 | £141,761 |
Looking at the most favourable result, a £141,761 ISA could generate £11,341 in passive income each year from dividend shares yielding 8%. But is it possible to achieve a return like this? Personally, I think it is.
For example, the 10 highest-yielding shares on the FTSE 350 are currently (23 January) offering a return of 10.6%. Having said that, care needs to be exercised. A high yield could be too good to be true. In other words, a value trap.
One to consider
My favourite dividend share and one worth considering is Legal & General (LSE:LGEN). Based on amounts paid over the past 12 months, it’s presently yielding 8.3%.
The pensions and savings group’s generous payout’s particularly important because, over the past five years, its share price has done – literally – nothing. A £10,000 investment made in January 2021 would be worth the same today but, over the same period, an investor would have received an impressive 98.28p a share (£4,027) in dividends.
Dividend sustainability is an important consideration when deciding which shares to buy. History can help here, to some extent. Legal & General last cut its payout nearly 20 years ago, during the global financial crisis. It even managed to keep it unchanged at the height of the pandemic.
As for making future predictions, this is tricky. The directors have pledged to increase the 2025-2027 payout by 2% a year. This can only be achieved if earnings go in the right direction. Fortunately, analysts are forecasting some healthy earnings growth over the next three years.
Both dividend and earnings forecasts can be wrong but it feels to me as though the group’s operating in a sector that’s likely to grow over the coming decades. With the State Pension age increasing and more people being encouraged to save for their retirement, interest in private pensions is increasing.
Yes, this is making the industry more competitive which could pose a threat. And with its large exposure to bonds and equities, the group’s vulnerable to market volatility. However, with its healthy balance sheet and strong brand, I think Legal & General’s an excellent dividend share to consider for the long term.
