The Stocks and Shares ISA limit of £20k a year emerged unscathed from the recent Budget. Indeed, it will remain at that level until 2030, providing the chance of tax-free passive income for years to come.
But even smaller sums can bring home the bacon. Here, I’ll look at how much passive income could potentially be generated through putting £750 a month — or £9,000 a year — into an ISA for the next 10 years.
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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Instant gratification
I reckon there are two main approaches an investor could consider taking here. The first is a straightforward one where the passive income would be taken regularly and ideally build over time.
For example, the forecast dividend for British American Tobacco (LSE: BATS) next year is 246p per share. This translates into a juicy forward dividend yield of 8.2%, based on the current 2,983p (December 2024) share price.
What that means in practice is that an investor could buy £750 worth of shares now to target roughly £61 in dividends next year.
After 10 years of such a return, assuming no capital appreciation or depreciation, the final portfolio balance would be £90,000. And by then it would be paying £7,380 in yearly passive income.
Now, this calculation assumes a constant yield of 8.2%, which is unlikely to be the case in reality. Monthly market fluctuations would cause the share price, and therefore the yield, to vary.
More than one egg in the basket
Moreover, relying on just one stock for passive income is too risky. Dividends aren’t guaranteed. And while British American Tobacco has an excellent track record of increasing its shareholder payouts, it’s also faced with fewer smokers on average around the world.
The company’s strategy relies on increasing the price of cigarettes, while investing heavily in developing leading smokeless brands like Vuse (vaping) and Velo (oral nicotine pouches). If either part of the strategy fails, then the current dividend might not be sustainable long term.
Delayed gratification
The second approach would involve reinvesting any dividends received. In other words, buying more shares rather than taking the income out of the account to spend (that could happen later).
A £9,000 ISA yielding 8.2% would pay £737 a year in dividends. At British American Tobacco’s current share price (just under £30), that would be enough to purchase an extra 24 shares. These would then pay an extra £59, and so on.
The benefit of such a strategy is that it would turbocharge the wealth-building process over time.
| Year | Accrued Interest | Balance |
|---|---|---|
| 1 | £338 | £9,338 |
| 2 | £1,442 | £19,442 |
| 3 | £3,374 | £30,374 |
| 4 | £6,203 | £42,203 |
| 5 | £10,002 | £55,002 |
| 6 | £14,851 | £68,851 |
| 7 | £20,835 | £83,835 |
| 8 | £28,047 | £100,047 |
| 9 | £36,590 | £117,590 |
| 10 | £46,570 | £136,570 |
The total after 10 years could be £136,570, not £90,000. And the annual passive income could consequently be higher, at £11,198. That’s nearly £4,000 a year more compared to not reinvesting!
Worthy of consideration
I should mention that I bought British American Tobacco shares for my own portfolio in March at 2,386p. So I’m up 25% so far, without factoring in the dividends (the stock was yielding almost 10% back then).
There are risks, as highlighted earlier. But the tobacco stock continues to look undervalued to me, making it a potential option to consider for a diversified ISA. That’s provided it aligns with an investor’s ethical stance.
