With the annual noise around the ISA contribution deadline that falls this weekend, it is easy to tune out if you do not have an ISA. But could an ISA offer a convenient vehicle for someone to put some spare money to work and try to use it to generate passive income?
I think so – here’s how.
Thinking of what an ISA could do for you
A Stocks and Shares ISA is basically just a platform for buying, holding, or selling shares. It is essentially like a share-dealing account and many of the features are the same or similar.
But there is one major difference: the tax treatment. Capital gains or dividends in an ISA do not attract tax.
The annual dividend allowance for income taxpayers now stands at only £500. Still, for someone putting £3,000 to work, that might mean they could earn their dividends without paying income tax on them even outside an ISA wrapper.
However, investing is about aiming to build wealth over time. Dividends can shrink or be cancelled, but they can also grow.
So, from a long-term perspective, I think even an investor with a few thousand pounds to spare ought to consider the potential merits of a Stocks and Shares 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.
Here’s how an ISA can generate passive income
Once the money is in an ISA, though, how might it start to make income?
The first step is to start investing, in shares that hopefully will pay dividends. Such payouts can come and go even at a successful business. So, as well as spreading the money over some different shares (£3k is enough to do that), it is important to choose carefully when looking for shares to buy.
There is lots to learn in the stock market, from valuation to understanding the cash flows that underpin dividends. When someone starts investing, I think it makes sense to learn about key elements and also take a conservative approach to managing risks.
It may sound surprising, but I reckon that many new investors could improve their returns if they spent as much time looking at the risks of the shares they buy as they do at the potential rewards.
The current FTSE 100 yield is 2.8%. At that level, £3k could earn around £84 of passive income per year. But I think a higher yield is possible while still sticking to high-quality businesses.
Household name yielding close to 8%
For example, one higher-yielding FTSE 100 share I think investors should consider is financial services company Standard Life (LSE: SDLF).
With its current yield of 7.9%, it is among the most lucrative dividend payers in the top-flight share index.
It also aims to keep growing its dividend per share annually as it has been doing in recent years. Of course, whether that happens in practice will depend on how well the business does.
Standard Life is only one of the brands the company uses in its large retirement savings and income business. With around £300bn of assets under management and some 12m customers, it is a sizeable operation that can generate large free cash flows.
An economic downturn could hurt investment returns, eating into the firm’s earnings. Even considering that risk, I still see the share as having strong long-term income potential.
