A Stocks and Shares ISA is a long-term investment vehicle and many investors keep dividends inside the tax-free ISA wrapper to reinvest. But an alternative is to take them out along the way as passive income, while leaving the capital untouched so that hopefully it can keep producing a stream of dividends year after year.
How could this work in practice?
Below I illustrate how a £20,000 ISA could potentially generate a £1,500 passive income each year.
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Choosing the right ISA
The first thing to consider is what Stocks and Shares ISA to use. After all, there are lots on the market.
They each have differences, for example, in cost or service level. Each investor is also different, so I believe it makes sense for everyone to do their own research and choose the ISA they think suits them best.
With the £20k in it, the ISA would then be ready to invest and start generating passive income.
Getting the basics right
Whether investing for income (as here), growth, or a mixture, certain principles of good investing apply.
For example, spreading the £20,000 across a range of different companies would help reduce the impact on passive income streams if one of them cancels its dividend. That is always a risk, no matter how strong the company looks today.
How much could a £20k ISA earn?
Is it realistic to aim for a £1,500 annual passive income from a £20,000 investment?
I think it is in today’s market, even while sticking to blue-chip businesses with proven models. The amount of passive income earned annually is a function of dividend yield.
£1,500 is 7.5% of £20,000, so an average 7.5% dividend yield would be required to hit the target.
That is only an average: some shares in the ISA may yield less and others more.
One income share to consider
For investors with a passive income focus, one share to consider is FTSE 100 financial services firm Legal & General (LSE: LGEN).
The company reported its annual results this week and they included a dividend increase of 5%. That has been the norm over the past several years, although from next year the company plans a 2% annual increase. That is slower growth but it is still growth. The share already yields 8.8% and if the dividend keeps growing, the prospective yield could be higher.
With a strong brand, large customer base and resilient demand for retirement-linked products, I think Legal & General is a solid business. Its pre-tax profit last year was over half a billion pounds.
But the sale of a US business could mean smaller profits in future, while there is a risk that a US stock market crash could hurt investor confidence and lead to some policy holders pulling out funds.
I am also a bit wary of management’s enthusiasm for buying back its own shares. That may indicate a lack of attractive growth opportunities for the business as it could otherwise use the money on them.
Still, I see a lot to like about Legal & General and reckon it offers significant passive income potential.
