How to turn a £20k ISA into a £9,386 yearly second income

Dividends can offer a superb second income. Our writer outlines his thinking and what he’d do to try and make it happen.

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.

Mature Caucasian woman sat at a table with coffee and laptop while making notes on paper

Image source: Getty Images

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

One of my preferred routes to earning a second income is by investing in dividend shares. That’s because I’d expect to receive regular payments that grow over time.

Recent spikes in inflation have shown why it’s important for income to at least keep pace with rising prices.

The second income plan

Today, I’m considering the best way to turn a Stocks and Shares ISA into an income-generating machine.

First, to create a £9,386 annual second income, I’d need a sizable pot to begin with. A single £20,000 investment is unlikely to be enough without taking excessive risks, in my opinion.

That said, by diligently investing £20,000 every year for just five years, I calculate that I should be able to build an ISA worth over £117,000. And given an 8% dividend yield, that should be enough to reach my income goal, although as always, it’s not guaranteed.

Finding dividend shares

The average dividend yield in the FTSE 100 is 3.8%, so I’d need to search a bit deeper to find suitable candidates.

Perhaps I could buy shares that offer the largest dividend yields. For instance, Vodafone currently offers a whopping 10%.

That might work out ok, but I’d consider a few other points before making my selection.

A large yield might not be sustainable. Bear in mind that dividends aren’t guaranteed. Company management can decide to cut, or suspend, payments if there’s a risk to earnings.

One way to measure affordability is by looking at its dividend cover. This shows how many times a dividend can be paid from a company’s earnings. To allow for a margin of safety, I’d consider any figure above 1.5.

Vodafone has a dividend cover of 1.0. And as that doesn’t meet my criteria, it’s not one I’d consider buying right now.

What I’d buy

Instead, I’d buy Phoenix Group, Legal & General, British American Tobacco, Aviva, and Lloyds Banking Group.

On average, this collection offers a yield of 8% and a dividend cover of 1.8.

On an initial £20,000, I’d expect to receive £1,600 of income in the first year. But while I’m building the pot over the first five years, I wouldn’t spend my dividends on clothes or gadgets.

Instead, I’d reinvest them to buy more shares. By doing so, next year I should receive dividends on my original shares and my new ones.

Reinvesting dividends like this has a powerful compounding effect that can amplify my income over time.

Comfort zone

My five chosen dividend stocks have been paying regular income to shareholders for many years, so they offer an excellent track record.

Although it doesn’t guarantee that they will continue to do so forever, it provides me with some comfort and reassurance.

Bear in mind that much can change to businesses, so I’d need to monitor the stocks I own to ensure they continue to offer reliable dividends. But with a small selection, that shouldn’t be too difficult.

If I’m patient, it may not be too long before my plan allows me to spend some of that second income. I already know what I’m going to buy.

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.

Harshil Patel has no position in any of the shares mentioned. The Motley Fool UK has recommended British American Tobacco P.l.c., Lloyds Banking Group Plc, and Vodafone Group Public. 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.

More on Investing Articles

Young female business analyst looking at a graph chart while working from home
Investing Articles

After collapsing 28% today, are Bunzl shares too cheap to ignore?

A poor trading statement has sent Bunzl shares to multi-year lows. Could now be a good time to consider investing…

Read more »

Investing Articles

These 5 stocks could earn £1,600 of annual passive income in a £20,000 ISA

Harvey Jones shows how to generate a high and rising passive income by buying a balanced mix of high-yielding FTSE…

Read more »

Young woman holding up three fingers
Investing Articles

3 things I like about Greggs shares

Greggs shares have tumbled by more than a third over the past year. But this writer has no plan to…

Read more »

artificial intelligence investing algorithms
Investing Articles

Nvidia stock: beware the bear market rally

Andrew Mackie argues that investors should tread carefully before investing in Nvidia stock, as the worst of the sell-off could…

Read more »

Young black colleagues high-fiving each other at work
Investing Articles

Up 73% in one year, is this the best value stock in the FTSE 100?

A brilliant run of form suggests this FTSE 100 giant should no longer make the cut as a value stock.…

Read more »

Investing Articles

The best could yet be to come for UK shares! I’m buying these ones

Amid ongoing stock market turbulence, this writer's been adding selected UK shares to his portfolio. Here's why and what he…

Read more »

Top Stocks

4 UK stocks trading well below book value to consider buying

Sometimes, it pays to be contrarian: who says the UK market has priced a stock precisely right, anyway?

Read more »

Investing Articles

The S&P 500’s 12% off its highs. Is now a good time to buy US shares for an ISA?

Right now, a lot of British investors are wondering whether it’s a good time to buy US shares. Here, Edward…

Read more »