A Stocks & Shares ISA allows us as UK investors to invest up to £20,000 a year without paying tax on capital gains or dividends. It’s a really excellent vehicle for our investments. But what are the best stocks to buy to transform our ISAs into passive income? Let’s take a closer look.
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.
Picking dividend stocks
Naturally, if we want to turn a lump sum into passive income, we need to invest in dividend stocks. And right now, there are a host of companies with sizeable dividend yields, especially on the FTSE 100.
But when picking dividend stocks we need to do our research. Big dividend yields might look attractive, but sometimes it pays not to trust them.
Part of that research is looking at dividend coverage. This ratio tells us how many times a company can pay its stated dividends from earnings.
A ratio above two is broadly considered healthy, but cash flow is also a factor. Some companies with lower ratios have better cash generation than those with higher ratios.
Dividends versus growth
Clearly, we’re not picking growth stocks here. But when it comes to dividend stocks it’s important to recognise that some companies offer very little in the way of share price gains.
For example, Legal & General and Phoenix Group both offer dividend yields above 8%. They’re also well-run businesses in the insurance sector. But they offer very little in the way of share price growth. That’s indicated through historical share price gains, but also management’s preference for dividends and not share buybacks.
If I really wanted to maximise these dividend returns, or I was using a compound returns strategy, I’d buy these stocks. In fact, I own both of them.
But today, I’m looking at companies that could offer some share price gains in addition to dividends. As such, I want to achieve a yield around 6%. This would allow me to turn a £20k ISA into £1,200 a year.
Where to invest
The FTSE 100 has a host of established companies offering attractive dividend yields. I’m starting with Lloyds. The bank offers a 5.4% dividend yield, but analysts anticipate another sizeable rise in the dividend next year — to 3p. I’m concerned about bad debt in the near term, but the longer picture is much brighter. It could be undervalued by as much as 50%.
Housing is another place to look. Most companies in the sector offer a dividend far in excess of the index average — around 3.5%. Vistry Group offers a 6.8% yield and is among the best performing stocks in the sector — that’s partially because its partnerships business makes it more resilient than it’s peers.
Looking at energy, I like funds such as The Renewables Infrastructure Group. It currently offers a 5.6% dividend yield and trades at a 7% discount versus its NAV.
