When I invest for passive income, I like to use a Stocks and Shares ISA. With no taxes due on capital gains or dividends within the ISA wrapper, it’s an excellent investment vehicle to use in order to maximise my stock market returns.
Currently, UK investors can park £20,000 each tax year in an ISA. So, if I made full use of the limit for a decade, how much dividend income could I expect to receive? Let’s explore.
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.
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ISA investing
Depending on the broker, investors can buy a range of assets in an ISA. These include funds, bonds, individual shares, commodities, and more. Since passive income is my priority, I’m focusing on dividend stocks.
Investing in companies for the regular payouts they offer isn’t a risk-free endeavour. Dividends aren’t guaranteed, for a start. Firms can cut or suspend their distributions to protect their balance sheets when the going gets tough.
In addition, it’s difficult in the current macroeconomic climate to protect a portfolio’s purchasing power. With inflation rates running hot, I’d need strong returns just to keep up with increasing prices.
That said, equities have historically been a good hedge against inflationary pressures. This is especially true if I’m prepared to invest for the long run. In doing so, I can ride out the inevitable share price volatility my holdings will experience during my investing journey.
The 10-year landmark
The FTSE 100 index was founded in 1984. Since its inception, annual returns have trended between 6% and 8% over long periods. The benchmark currently offers a 3.8% dividend yield.
With well-chosen stock picks, I might be able to secure higher returns and a larger yield. But this is far from guaranteed. Accordingly, I think it’s prudent to use these numbers as the basis for my forward-looking assumptions when modelling my portfolio’s growth.
So, if I invested £20k in my ISA every year for a decade, I could potentially expect a portfolio worth £293,098 at a 7% compound annual growth rate.
With a 3.8% dividend yield across my positions I could expect £11,138 in tax-free annual passive income. This would certainly be a very handy boost to my income, but there are merits to delayed gratification. If I left my portfolio to compound further, the potential long-term rewards could be huge.
A longer time horizon
By electing to reinvest dividends into more stocks within my ISA, over time my passive income portfolio could balloon.
Assuming I made no further contributions and my shares continued to deliver the same returns, here’s what my progress over the next 20 years could look like.
| Year | Portfolio value |
|---|---|
| 15 | £411,085 |
| 20 | £576,568 |
| 25 | £808,667 |
| 30 | £1,134,197 |
The above table illustrates the power of compound returns over time. If I put this plan into action at the age of 30, by the time I reach 60 I could receive a whopping £43,100 every year in tax-free dividends!
Granted, my projections rest on some key assumptions. Stock market crashes and prolonged bear markets pose major risks to my neat calculations.
Nonetheless, for investors who can afford to maximise their ISAs every year, it might only take a decade of contributions to build a nest egg that sets them up for life.
