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3 reasons why I’d buy FTSE 100 dividend stocks in an ISA to generate a passive income

Investors seeking to generate a passive income may be dissuaded from buying FTSE 100 shares due to their high recent volatility. This could continue in the coming months, with factors such as political risks and uncertain global GDP growth prospects having the potential to weigh on the index’s performance.

However, in the long run, the index appears to offer income appeal. Its income return is significantly higher than that offered by other mainstream asset classes, while tax-efficient accounts such as a Stocks and Shares ISA could lead to impressive net returns.

Furthermore, with the index offering long-term capital growth potential, now could be the right time to buy a diverse range of FTSE 100 shares.

Income prospects

At the present time, the FTSE 100 has a dividend yield of around 4.5%. This is significantly higher than the income returns available on other mainstream assets. For example, obtaining an interest rate greater than 1.5% on cash is difficult, while investment-grade bonds may also struggle to offer positive real-terms returns. Meanwhile, rising taxes and increasing house prices could mean that the net yields on buy-to-let investments are relatively low.

Furthermore, there is scope for dividend growth across the FTSE 100. It could benefit from its status as an internationally-focused index that has exposure to fast-growing economies, which may provide a tailwind to its members over the coming years.

Tax efficiency

A Stocks and Shares ISA is a simple and cost-effective means of investing tax-efficiently. It operates in much the same way as a standard share-dealing account, in terms of the investments that are available and the logistics of opening it. However, any capital invested through a Stocks and Shares ISA is not subject to tax, which means that investors can generate dividends in excess of the annual allowance of £2,000 without paying tax.

Therefore, investing through a Stocks and Shares ISA could allow you to net a 4.5% (or more) income return from investing in a diverse range of large-cap shares. Over time, this could produce a significant level of passive income, with a £20,000 annual ISA allowance likely to prove sufficient for most investors.

Growth potential

Alongside its passive income prospects, the FTSE 100 could deliver capital growth. This may, of course, be a secondary concern for income-seeking investors. However, it is easier to generate a generous income from a larger amount of capital, which could mean that the FTSE 100’s long-term growth outlook is relevant for all investors.

The index may have risen only modestly in the last 20 years, but its performance from inception in 1984 to the peak of the tech bubble in 1999 shows that it can deliver strong returns. During that time, it increased almost seven-fold in value. With a high current yield, the next 15-20 years could produce improving capital returns across the index, thereby making now the right time to buy a range of large-cap shares.

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Peter Stephens has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.