Stuffing an ISA with dividend shares is one approach to trying to build passive income streams. So how much would need to be invested – and at what point might the income start rolling?
Understanding the role of dividend yield
Key to that answer is the simple concept of dividend yield. Put simply, this is the amount of dividends received from a portfolio, expressed as a percentage of its purchase price.
To Illustrate, imagine the ISA can achieve a 5% yield, markedly higher than the current FTSE 100 average, but still realistic in the current market as I see it.
Earning £750 a month of passive income would mean the ISA needs to generate £9k a year in dividends. At a 5% yield, that would require an ISA to be worth £180k.
Using an ISA contribution allowance to my advantage
Now, like many investors I have nowhere near a spare £180k in a Stocks and Shares ISA sitting idle. So imagine I wanted to start from scratch in an empty ISA.
Most investors are allowed to put £20k a year into their ISA.
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Doing this would take nine years to build up to £180k. But it is possible to speed things up by reinvesting (compounding) dividends initially rather than taking them out as passive income.
Starting from zero, contributing £20k a year and compounding at 5% annually, it would take eight years for the ISA to top £180k in value.
Making some smart choices
Something that can eat into the actual yield of an ISA (even if the shares within it yield 5%) is the fees and commissions charged by the ISA provider. So it makes sense to shop around when looking for the most suitable, competitive Stocks and Shares ISA.
It is also important to manage risk by spreading the ISA over a diversified range of shares.
On top of that, of course, what shares someone chooses matters too.
One share to consider
In short, to hit the 5% target, shares with a juicy yield will help.
But there are a couple of caveats. First, it is important not just to look at the share’s current yield but to consider what the business looks able and likely to pay in future. Dividends are never guaranteed.
Secondly, even with dividends in mind, investors need to be mindful of the risk of a share price falling. Potentially that could effectively cancel out the impact of dividends while someone owns the share.
One share I think investors should consider is British American Tobacco (LSE: BATS).
Strong cash generation
The dividend part of the equation here is pretty straightforward. Making cigarettes then selling them under premium brands like Dunhill is cheap but can command a high cost. So British American is a cash flow generation machine.
It uses that cash flow to help fund a dividend that currently yields 5.3%. The FTSE 100 company has grown its dividend per share annually for decades and aims to keep doing so. Falling cigarette sales volumes are a risk to profits though, that could ultimately affect both dividend and share price.
What about the current share price? It has gone up 85% in five years.
So the share is more expensive than it was but I still think it is worth considering, for an investor who does not shun tobacco stocks on ethical grounds.
