Turning an empty ISA into a second income of £40k a year!

Earning a second income is a key objective for many stock market investors. Here’s how our writer would aim for £40k a year starting from scratch.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

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Investing in dividend stocks can be a great way to earn a second income. With no tax due on dividends or capital gains and a £20k annual allowance to take advantage of, I’d use a Stocks and Shares ISA to pursue this goal.

But, how long would it take me to generate £40k in dividends every year starting from zero? Let’s crunch the numbers.

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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Buying dividend shares

Since earning passive income is my chief objective, I’d focus on maximising my portfolio’s yield by investing in dividend shares.

UK investors are spoiled for choice. Compared to other leading global stock market indexes, the FTSE 100 and FTSE 250 have some of the highest concentrations of income-producing companies.

When searching for dividend stocks to buy, it’s important to look beyond the headline yield figure. Robust dividend cover and a reliable history of shareholder payouts are crucial factors that influence my decision to invest.

That’s because I prioritise dividend sustainability. Although no distributions are guaranteed, some stocks carry lower risks than others. Generally, dividend cover of two times earnings or more is a good indicator of safety.

Examples of dividend shares I own include:

StockDividend YieldDividend Cover
Diageo2.4%2.0x
Lloyds5.6%3.0x
Tesco4.4%2.0x

I wouldn’t confine myself to British shores either. An attractive way to gain overseas exposure could be to invest in an exchange-traded fund (ETF), such as the ProShares S&P 500 Dividend Aristocrats ETF.

This fund tracks the performance of the S&P 500‘s Dividend Aristocrats — companies that have consistently hiked their dividends for 25+ years.

Compound returns

Imagine I secured a 4% dividend yield across my holdings. That means I’d need a £1m stock market portfolio to earn a second income of £40k per year.

If I maximised my ISA contributions every year starting with nothing, it would take me a little over 20 years to achieve that goal at an 8% compound annual growth rate (CAGR), accounting for capital gains and dividend reinvestments.

Although an 8% CAGR is in line with the stock market’s historic performance, it’s prudent to model different rates of return. After all, past performance doesn’t guarantee future returns.

For instance, at a 6% CAGR, I’d need to expand my investment horizon to over 23 years. And at a 4% CAGR, I’d need to wait nearly 28 years until my annual dividend haul reached £40k.

In addition, it would be challenging to contribute £20k every year to an ISA. But, for investors who can afford it, the tax-free rewards are potentially great.

Risk management

Dividend investing isn’t risk-free. As I’ve alluded to, companies can cut or suspend their dividends if they encounter financial difficulty — including the examples I’ve provided in this article.

If companies I owned reduced payouts or stopped paying me passive income altogether, that would derail my neat calculations.

Diversification is a useful way to manage these risks. By spreading my investments across different businesses and sectors, I wouldn’t be overly reliant on any single stock to earn a second income.

Plus, the potential rewards over time are significant. Cash savings have rarely kept pace with inflation over long periods, so I’m buying dividend stocks to meet my passive income needs.

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Charlie Carman has positions in Diageo Plc, Lloyds Banking Group Plc, and Tesco Plc. The Motley Fool UK has recommended Diageo Plc, Lloyds Banking Group Plc, and Tesco Plc. 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.

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