The main reason I invest in stocks and shares is to generate a second income from company dividends to fund my retirement. I’m certainly not going to rely on the UK State Pension. Yes, it’s a reliable safety net, but depending entirely on it is a pathway to misery.
The Stocks and Shares ISA is a brilliant way to build that income, as everything I take will be free of tax.
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.
Someone who gets the new full state pension of £10,600 a year today, plus a further £20,000 from an ISA, would be earning north of £30,000 before paying a penny in income tax. That’s bad news for HMRC but good news for ISA investors.
Start planning young
I’ve set myself a target of generating £17,500 of income a year, from an initial investment of £20,000. I’m already beginning to regret that, because it sounds impossible. Yet success depends on how far off retirement is.
Let’s say I was 30 years old and invested this year’s full ISA contribution limit in FTSE 100 shares, and matched the long-term average total return on the index of 6.89% a year. Assuming a retirement age of 67, that £20k would have plenty of time to compound and grow.
After 37 years, it would have grown to £235,343. If the average yield on the shares in my portfolio was 7.5%, they would generate income of £17,650 a year. That’s a pretty good return on my original, relatively modest, sum of money.
This shows the power of long-term investing, especially in dividend stocks, as small initial sums can really roll up over the decades.
Yet there are obvious problems with my figures. It takes a good few decades to turn £20,000 into £235,000. An older investor almost certainly couldn’t do it unless they took outsized investment risks and they mostly paid off.
I’d buy shares like these
Another danger is that my shares could generate a lower return than 6.89% a year (although they might do better). Plus of course inflation will erode the value of that income in real terms.
Generating income of 7.5% a year may sound a tall order, yet in my defence, plenty of FTSE 100 stocks return that today. For example, housebuilder Barratt Developments yields 7.73% a year, while insurer Aviva yields 7.75% and British American Tobacco pays income of 8.18% a year.
At the higher end of the yield scale, Vodafone Group pays 9.66% a year and asset manager M&G returns a whopping 10.21%. So I think my portfolio target is doable.
Dividends aren’t guaranteed and can be cut or scrapped at any time. High yielders are particularly vulnerable. That’s why I would invest in a balanced portfolio of at least a dozen FTSE 100 stocks, so if some struggle, others will hopefully compensate.
Also, I wouldn’t stop at investing £20,000, regardless how young or old I was. I’d aim to use as much of my ISA allowance as I could afford every year, to generate the maximum possible dividend income and share price growth. By doing that, I would hope my second income is much higher than £17,650 a year by the time I retire.
