The Stocks and Shares ISA is a miraculous tool for building a passive income. By capitalising on the annual ISA allowance, investors can inject up to £20,000 each year into the stock market without paying a single penny in capital gains or dividend tax.
In the future, this allowance might be higher or lower. Therefore, it’s essential to try and maximise its usage since it doesn’t carry over into the next tax year. But the question then becomes, how to use it effectively?
Eliminating tax from the equation
An investor capable of maximising their annual ISA allowance will most likely be in the higher rate income tax band. This is important because outside of an ISA, they’ll be paying 33.75% tax on any dividends received.
Passive income stocks: our picks
Do you like the idea of dividend income?
The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?
If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…
Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.
What’s more, today we’re giving away one of these stock picks, absolutely free!
To demonstrate how much damage causes the wealth-building process, let’s assume that £20,000 is invested each year over the next decade, yielding 6% in dividends that are reinvested.
Within an ISA where taxes don’t apply, a portfolio would reach a value of roughly £273,187. But in a regular trading account, the impact of dividend tax drags the portfolio’s performance down to £245,142.
In other words, investors using an ISA to build a passive income end up being up to £28,045 richer. And that’s not even taking any capital gains into account.
Of course, I’m ignoring the annual £1,000 dividend allowance in this calculation. But considering it’s dropping to £500 in April 2024, this shrinking tax-free buffer becomes near negligible as a portfolio grows.
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.
Building a sustainable passive income
Buying shares in a low-cost index fund is probably the most prudent for hands-off investors who don’t want to spend time researching and analysing stocks.
Mimicking the performance of flagship indices like the FTSE 100 or FTSE 250 is a proven strategy. However, both don’t offer much in terms of yield, with neither currently above 4%. For investors seeking to maximise their passive income, picking individual stocks can unlock a more substantial payout without substantially increasing risk.
It’s also worth pointing out that building a high-yield portfolio doesn’t always require buying high-yield stocks. Investing in businesses with the potential to steadily grow their dividends over time can push a portfolio’s yield higher. And the firms capable of doing this consistently often end up being some of the most lucrative investments around.
Of course, stock picking isn’t a straightforward process. Beyond a time investment it requires far more emotional discipline, especially when stock prices are in freefall.
It also demands some notable skill in capital allocation. After all, unlike an index fund, investors will have to construct and manage their own portfolio of companies, ensuring everything stays diversified and balanced.
This extra effort isn’t for everyone. But investors able and willing to design, develop, and execute a sound investment strategy could unlock a significantly larger passive income in the long run.
