Can I earn enough tax-free passive income every year to secure financial independence? Like many investors, I’m aiming for this goal. I believe it’s possible by investing in a carefully selected portfolio in a Stocks and Shares ISA.
This tax year, I have a £20,000 limit that I can contribute to my ISA. With a long investment horizon stretching decades into the future, I could harness the power of compound returns to build a mammoth dividend portfolio.
So, here’s how I’d target £40,000 in annual passive income if I started investing today.
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Diversification
As I’m at an early stage in my journey, I’d invest in a mix of growth and dividend shares.
Growth stocks would provide me with exposure to companies that are expected to boost their earnings at a faster rate than the market average.
By contrast, income-producing companies tend to have a greater focus on delivering steady returns and regular dividend payments.
The logic behind my decision to invest in both is diversification. I’d gain exposure to separate areas of the stock market that can respond in different ways to macroeconomic conditions.
Growth stocks
One FTSE 100 company I own shares of is Scottish Mortgage Investment Trust, a fund that focuses on some of the most innovative companies around the globe.
Recent returns have been disappointing, which shows the potential pitfalls of growth stock investing. Nonetheless, the trust has a long history of beating the market in bygone years.
I hope that when the economic environment improves, the Scottish Mortgage share price will appreciate at a faster rate than FTSE All-World Index that the company uses as a benchmark.
Dividend stocks
Further down the line, I’d boost my concentration in dividend shares. That’s because these firms often have robust balance sheets and long track records of profitability.
Accordingly, by owning a greater number of dividend stocks, I’d aim to reduce my volatility risk as I approach retirement. In addition, this means I may not have to sell my shares to live comfortably from my portfolio’s returns, thanks to the regular passive income streams they provide.
Dividends aren’t guaranteed. However, by spreading my investments across a range of sectors, I hope I could rely on shareholder payouts from at least some of my holdings if any single company axed or suspended its dividend.
Currently, I own various FTSE 100 dividend shares in different industries. These include tobacco, pharmaceuticals, banking, mining, housebuilding, and groceries.
| FTSE 100 stock | Dividend yield |
|---|---|
| British American Tobacco | 8.0% |
| GSK | 5.4% |
| Lloyds | 5.2% |
| Rio Tinto | 8.2% |
| Taylor Wimpey | 7.4% |
| Tesco | 3.9% |
Time is my friend
Because dividend income and capital gains inside a Stocks and Shares ISA are awarded tax-free treatment, I’d reinvest my dividends within the ISA wrapper.
Let’s assume the £20k annual allowance remains unchanged. If I secured a 7.5% compound annual growth rate on my investments, it would take me 20 years to build a £1m+ portfolio by maximising my contributions every year.
At a 4% dividend yield, I’d earn £40,000 in annual passive income after just two decades!
Of course, my stocks could underperform. That would delay my progress or even send it into reverse. But, with time on my side, I could eventually earn tax-free income for life.
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.
