It’s fairly easy to build a tax-free second income. For me, the simplest route is investing in a portfolio of UK shares through a Stocks and Shares ISA.
Top FTSE 100 and FTSE 250 companies don’t just offer the chance of share price growth, they also pay regular dividends, rewarding investors even in years when the shares struggle. Reinvest those dividends and the total return can compound into a sizeable income over time.
It’s not essential to use shares, of course. A Cash ISA can currently pay around 4% a year, with no risk to capital. That’s attractive, especially for short-term savings. But is it attractive enough?
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Stocks and shares options
Let’s say someone wants to generate a second income of £500 a month, or £6,000 a year. At a 4% return, they’d need a nest egg of roughly £150,000. Perfectly achievable, but it means missing out on the higher long-term returns shares have historically delivered. Over time, the FTSE 100’s generated average annual returns closer to 8%, combining share price growth with reinvested dividends.
The difference is striking. Someone saving £250 a month into a Cash ISA paying 4% would reach £150,000 in just under 28 years. Invest the same amount into a share portfolio returning 8%, and they’d get there in just over 20 years, eight years sooner.
Carry on investing for the full 28 years and the shares would be worth more than £300,000, double the size of the cash pot. The real benefits of buying equities that compound and grow over time.
Many new equity investors keep things simple by buying a tracker fund, perhaps following the FTSE 100, the US market, or a global index of shares. That’s a perfectly sensible approach.
At The Motley Fool though, we favour building a diversified portfolio of individual UK stocks. Done well, this can generate higher dividend income and stronger long-term growth. Stock-picking is more hands-on though, and comes with more risk.
GSK share price finally rises
One FTSE 100 stock worth considering is GSK (LSE: GSK). The pharmaceuticals and vaccines giant has endured a difficult decade, as it worked to replace blockbuster drugs that had gone off patent. Developing new treatments is slow, expensive and risky, with tough regulatory hurdles along the way.
GSK was once famed for its dividend, but payouts were frozen for years as cash was funnelled into rebuilding the pipeline. Now the hard work appears to be paying off. The share price has jumped 50% in the past 12 months.
I bought the stock 18 months ago as a recovery play, and after an early dip, my patience is finally being rewarded. GSK doesn’t look expensive, with a price-to-earnings ratio of about 12.5. The trailing dividend yield is a modest 3%, but there’s scope for growth over time. There are still risks. The GSK share price may slow after the recent strong run. It needs to keep working on that pipeline, to boost revenues and margins. But I think it’s well worth considering with a long-term view.
Dividend shares can be far more rewarding than cash over the long term, but investors must be willing to stay patient and ride out the bumps along the way.
