I use a Stocks and Shares ISA to fulfil many of my investing needs. With a generous £20k annual contribution limit and no taxes on capital gains or dividends, using an ISA can be a great way to buy stocks and earn a second income.
Imagine I wanted to aim for a passive income stream of £10,000 a year from one year of maximum ISA contributions. How would I approach this objective? And how long would it take to earn a five-figure dividend haul?
Let’s explore.
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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.
Buying dividend stocks
It’s important to distinguish between income-generating shares and stocks that don’t pay dividends. Since earning passive income is my priority, many popular companies wouldn’t be suitable investments because they don’t issue regular distributions. So, that rules out the likes of Amazon, Meta, and Tesla.
This leads me to wonder which stocks I should consider buying
Fortunately for investors seeking exposure to UK shares, almost all FTSE 100 businesses provide shareholders with cash payouts. Companies in Britain’s leading index generate the vast majority of their aggregated income from overseas. However, I’d also consider buying US dividend stocks for additional portfolio diversification, as well as shares from other international markets.
Currently, my stock market positions span a variety of firms in different sectors. I focus on several metrics when investing for a second income, such as the stock’s dividend yield, dividend cover, and the company’s dividend history. Examples of dividend shares I own include:
| Dividend stock | Forecast yield | Forecast cover |
|---|---|---|
| British American Tobacco | 9.5% | 1.6x |
| GSK | 3.9% | 2.6x |
| Johnson & Johnson | 3.0% | 2.1x |
| McDonald’s | 2.4% | 1.9x |
| Rio Tinto | 6.8% | 1.7x |
Earning a second income
To accelerate my journey towards earning £10k in annual passive income, I’d reinvest my dividends within a Stocks and Shares ISA. Not only is this tax-efficient, but pursuing this strategy allows me to benefit from the power of compound returns over time.
If I secured a 5% yield across my stocks, I’d need a portfolio worth around £200k. In essence, my ISA would need to increase tenfold in value. That’s no mean feat, but I can factor share price appreciation into the equation too.
The compound annual growth rate (CAGR) of my combined holdings would dictate how long this would take. To illustrate this, here’s what my journey to a five-figure dividend income could look like at different rates of return.
| Portfolio CAGR | Time taken |
|---|---|
| 5% | 47 years, 3 months |
| 7.5% | 31 years, 11 months |
| 10% | 24 years, 2 months |
| 12.5% | 19 years, 7 months |
No guarantees
Turning a £20k ISA into an income generator that would yield 50% of my original investment takes time and demands patience. But, aided by some smart stock picks, I could potentially achieve this goal in less than two decades!
That said, my modelled scenarios assume a positive return. Over long time periods, volatility arguably becomes less of a concern. Even so, there’s a risk my stocks could underperform and deliver a negative return.
In addition, dividends aren’t guaranteed. So, if my portfolio’s yield dropped, I might need a larger investment pot to generate £10k in payouts.
Accordingly, although stock market investing can be a great way to earn a second income, investors should remain alive to the risks involved.
