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Earning passive income from an ISA is a simple and tax-efficient way to build the financial freedom many investors dream of. Dividend income and capital gains are free of tax, as are withdrawals. But how large would an ISA have to be to generate a steady £888 each month, or £10,656 a year?
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Using the 4% ‘safe withdrawal’ rule, which assumes investors can take 4% of their pot each year without running it down, that target would require around £266,000 invested.
It’s a chunky sum, but not unachievable. Someone investing £250 a month for 30 years, earning an average annual return of 7%, could end up with almost £273,000. Reinvesting every dividend along the way is key, as this produces the miracle of compound returns, which can turn modest contributions into a serious second income stream over time.
FTSE 100 dividend stocks can help
For those chasing an income, the FTSE 100 offers a wide choice of established dividend payers. Index funds tracking the blue-chip yield around 3.25% today, which would require about £330,000 to generate £888 a month. Investors who hand-pick higher-yielding stocks paying income of 6% on average can potentially reduce that to around £180,000.
It’s worth doing a bit of research to identify companies with reliable profits and sensible payout ratios. Insurers pay generous dividends today, and Aviva (LSE:AV) has delivered plenty of growth too.
Over the past year, its shares have surged 35%, and they’re up 143% over five years. During that time, the yield has slipped from as high as 7% to about 5.46%, but that’s mostly because the share price has climbed so fast.
Aviva’s dividend record hasn’t always been smooth. There were painful cuts in 2009, during the financial crisis, as well as in 2012 and 2013, and again in the pandemic. Yet when profits allow, the board has been quick to reward shareholders. Over the past five years, dividends have risen at an average annual rate of 23.2%.
Results on 14 August confirmed the momentum. Operating profit rose 22% to £829m in the first half, driven by price rises and stronger premium income. The interim dividend was lifted 10% to 13.1p. Chief executive Amanda Blanc deserves much of the credit for transforming Aviva since her appointment in July 2020.
Holding for the long haul
A word of warning. Aviva now trades on a price-to-earnings ratio of just over 27, well above the 15 that’s typically considered fair value. That suggests expectations are high, and sustaining this pace of growth could prove difficult, especially given the weak UK economy and fierce competition in the motor insurance market.
Many are concerned about a stock market crash at the moment, which would also hit Aviva, which has more than £400bn of assets under management. However, I still think it’s worth considering with a long-term view, while any market dip could also offer investors a tempting entry point.
Investing isn’t about timing the market but spending time in it. Building wealth slowly through reinvested dividends, diversification and taking the long-term approach can make that £888 monthly passive income goal a reality.
