Being able to invest up to £20,000 in a tax-free ISA gives us an opportunity to build a passive income stream. But how much could we realistically generate over the long term? Let’s look at what I consider a poor option first. And then we’ll get to the really good stuff.
Top Cash ISA rates are around 4.6%. That beats inflation, and a return’s guaranteed for the terms of any deal. It sounds great for a bit of cash savings, or for folks who don’t want any stock market risk at all.
But an ISA allowance of £20,000 today could grow to over £49,000 in 20 years. And it could then generate £2,260 annual passive income. But it would depend on reinvesting the interest each year, and we’d need Cash ISA rates to stay this high over the long term. When the Bank of England lowers base rates further, there’s surely little chance of that happening.
Better deal from shares?
FTSE 100 returns have averaged 6.9% over the past 20 years. So what might that get us? What about the same £20,000 invested in the iShares Core FTSE 100 UCITS ETF (LSE: ISF) tracker fund?
That aims to replicate the FTSE 100‘s performance. And if it succeeds — which it’s been doing quite nicely — it could turn £20,000 into around £76,000 in the same 20 years. The extra 2.3% could mean a difference of more than 55% in the long term.
After the two decades, we could be looking at a passive income of over £5,200 a year. That’s more than twice the income we saw from cash. Similarly, we’d need to reinvest any dividends we earn each year.
It also depends on the Footsie managing to maintain its returns. And the tracker maintaining a close match. But the past 20-year average is in-keeping with the UK stock market’s long-term results going back a century and more. So I reckon FTSE 100 index tracker returns have a better chance of being maintained than Cash ISA returns.
Investors might want to go 50/50 with a FTSE 250 tracker to spread the risk, which inevitably comes with any stock market investment.
Even better again?
We must have a good chance of beating that with something like Legal & General (LSE: LGEN). The first thing to notice from the above chart is that Legal & General shares have badly lagged the FTSE 100 over five years. But the further back we check, the better the record looks.
The big attraction is a forecast 8.9% dividend yield. That could turn a one-off £20,000 ISA investment into £110,000 in 20 years. And then pay an annual passive income of £9,800. Any share price gains would be a bonus.
Do I suggest putting all the eggs into the Legal & General basket? Absolutely, no. The insurance business can be very volatile, and the risk isn’t insignificant. Also, dividends aren’t remotely guaranteed.
But as part of a well-diversified ISA based on a strategy of seeking high-yield stocks, it has to be one to consider, right?
