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For many investors, the dream of living off passive income is closer than it seems. The stock market offers multiple ways to generate it, particularly through dividend-paying shares. But there’s a catch: without the right tax shelter, a hefty chunk of those returns can be swallowed by capital gains tax.
At present, UK capital gains tax is set at 18% for basic-rate taxpayers and 24% for higher earners. That means a significant portion of long-term investment gains could disappear into HMRC’s coffers. But here’s where the Stocks and Shares ISA comes into play. With an annual contribution allowance of £20,000, investors can shield both capital gains and dividends from tax altogether.
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.
Savings calculations
The savings over the long run are huge. Take a simple example: a £20,000 portfolio returning 10% a year on average, with dividends reinvested. That’s a relatively standard market average for many UK investors.
Left untouched for 20 years, this would grow to around £134,500. But outside of an ISA, an investor would owe capital gains tax on the £114,500 profit. At the basic 18% rate, that’s more than £20,000 lost in tax. Inside an ISA, those savings remain intact – and could be reinvested to generate even more passive income down the line.
So, while £20,000 a year may sound like a lot to put away, even smaller contributions can snowball into meaningful wealth when compounding works tax-free. That’s the beauty of ISAs for passive income investors.
Now, what stock might fit nicely into such a portfolio? One company that I think investors should consider as a starter holding is HSBC (LSE: HSBA).
Safety in numbers
HSBC is the largest bank in the UK and offers a dividend yield of around 5%, well above the FTSE 100 average of 3.2%. With a payout ratio of 65%, the dividend looks comfortably covered. Importantly, HSBC has a long track record of consistency – it’s delivered over 20 years of uninterrupted payments and has grown its dividend at an average of 4.5% per year since 2010.
For those seeking passive income, that level of reliability is attractive.
But it’s not without risks, though. HSBC is heavily exposed to Asian markets, which account for the bulk of its profits. While this provides growth opportunities, it also exposes the bank to geopolitical tensions and regulatory uncertainty. This operational split between East and West can be costly, with different compliance requirements and strategic priorities to manage. In the past, non-compliance issues have caused the bank reputational damage, something investors shouldn’t overlook.
Final thoughts
A Stocks and Shares ISA is a powerful financial tool that shouldn’t be overlooked by UK investors. The tax savings may seem small at first but when using a dividend reinvestment plan (DRIP), the compounding returns can add up to a significant amount.
Reliable dividend stocks like HSBC provide an excellent foundation for a diversified income portfolio.
Its strong capital position and consistent dividend record make it an attractive option for early investors looking to open an ISA. With compounding and tax-free growth working hand in hand, even its relatively modest yield could become a powerful driver of long-term passive income.
