An ISA can be a good way to generate passive income. Thanks to dividends paid by the companies in my Stocks and Shares ISA, I can earn passive income.
I have scoured the market to try and find what seems like the best Stocks and Shares ISA for me. After all, I do not want to earn passive income in the form of dividends only to end up using a lot of it to pay fees on my ISA!
Setting a target
How much passive income I can earn from my ISA depends on two things: how much I invest and the average dividend yield I earn.
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The average dividend yield is not fixed. After all, a company can cut or increase its dividend. So, even if I buy a share today that yields 9.2% — such as Legal & General (LSE: LGEN) — that does not mean that it will keep yielding 9.2%.
Indeed, Legal & General aims to grow its dividend per share by 2% annually in coming years. But it has also cut its dividend before, as happened after the 2008 financial crisis.
At 9.2%, Legal & General’s dividend yield is far above the FTSE 100 average of 3.6%. But I reckon that by investing in a mixed portfolio of blue-chip shares like Legal & General, I could realistically target a 7% average dividend yield right now without moving outside the FTSE 100 when hunting for shares to buy.
At that level, earning £500 per month (£6,000 annually) would require almost £86,000 invested in my Stocks and Shares ISA. Not only is that a lot, it is well above my annual ISA contribution allowance.
Investing for the long term
So, I take a multi-year viewpoint on setting up passive income streams. As well as contributing to my ISA regularly over time, I also try to increase its value by compounding dividends.
Even with a £20k lump sum, if I compound that at 7% annually, after 21 years I ought to have the amount I need in my ISA for a 7% yield to equate to over £500 per month in dividends.
If I keep adding to my ISA over time, I could speed that process up. That is what I am doing.
Finding shares to buy
What attracts me to a share like Legal & General for such a plan?
After all, its profits over the past couple of years have been smaller than in the years before that – and the share price is down by a quarter in the past five years.
The weaker profits do concern me and one risk I see is a weak economy hurting investment returns, potentially leading some policy-holders to switch providers. That could hurt profits.
But Legal & General has a lot of what I look for when hunting for shares to buy for my ISA.
It operates in an area I expect to benefit from strong long-term customer demand. The firm has competitive advantages, from its well-known brand to an entrenched customer base. I feel I understand the business and so can assess it.
Plus, crucially, it has proven its ability to generate excess cash – and willingness to use some of that cash to fund dividends.
