I’m convinced I know my best chance of building passive income from long-term investments. I reckon it has to be a Stocks and Shares ISA.
It does open me up to more risk than a Cash ISA, as they offer guaranteed interest rates. Well, for as long as the latest contract, at least. But when the Bank of England (BoE) gets inflation down to its target 2%, I think we’ll be lucky to see Cash ISA rates much above 1%.
I don’t see much point trying to save the tax on that level of income, not when total FTSE 100 returns have averaged something like 6.9% per year over the long term. It’s not guaranteed, of course, but history is behind it.
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Bad spells
To take home £10,000 a year from my ISA, I’d like to be able to not run down my capital too much. If the BoE meets its inflation target, I’d want to leave enough in my ISA to match.
That suggests I could take 4.9% of the average 6.9% per year, and leave the other 2% to keep up with rising prices. So how much might I need?
My sums suggest a pot of around £204,000. If the UK stock market keeps on going the way it has for the past century or so, I should be able to take my £10,000 from that and leave enough to keep up with inflation.
What’s the best way to actually take the cash? For me, that’s where dividends come in. Let’s pick a FTSE 100 stock to use as an example.
Bank dividends
I’ll go for Lloyds Banking Group (LSE: LLOY), because it has the closest dividend among my holdings to that target 4.9% income.
In fact, Lloyds is currently on a forecast dividend yield of 5.4%, so I could even leave a little behind to build up for next year and beyond.
But this does bring me to my first serious need for caution. Dividends are never guaranteed, and Lloyds is a good example of that. The bank had to suspend its dividend when the pandemic hit and the stock market crashed in 2020.
In fact, most of my dividends fell that year. So if I’d been drawing passive income I’d have needed to sell some shares to meet my goal.
Financial crash
Looking back further to the 2008 financial crash, Lloyds suffered a lot more pain back then and it took some time to get back to progressive dividends.
What’s the way to minimise risks like that? In a word, diversification. I particularly like investment trusts for that and I hold several. And I always aim to keep a variety of stocks from different sectors.
Oh, and I’m basing these figures on historic returns, which we might not get in future. Better to aim a bit higher, I think, rather than fall short.
For most of us, building a pot of £200,000 or more could take a few decades. Fortunately, I started investing in ISAs a long time ago. And I think my goals are realistic.
