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A Stocks and Shares ISA can provide a simple platform to try and generate passive income – and I think that is especially true over the long term.
Here’s how much income in the form of dividends a £20k ISA could hopefully generate over the coming decade.
Jam today, or jam tomorrow?
There are two different approaches to drawing down the dividends.
One is to take out the dividends as they come and use them as passive income. Once removed from the Stocks and Shares ISA wrapper, they will lose the tax-protected status they had in it. But this approach will hopefully mean passive income flows from the first year of the decade.
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.
Another approach is to reinvest dividends inside the ISA, something known as compounding. As they are still inside the ISA wrapper, these dividends will not eat up the annual contribution allowance.
So an investor taking that approach may end up having more than £20k of ‘new’ money to invest in their ISA in a given tax year, while staying inside the contribution allowance.
Dividend yield – and why not to chase it
How much passive income someone earns depends on how much they invest, and at what dividend yield.
Yield is the annual dividend income, expressed as a percentage of the price paid for the shares. So, for example, a 7.5% yield means £7.50 of dividends for every £100 invested.
That presumes the dividends flow: they are never guaranteed and a company may choose to grow its payout, but it can also cut or cancel it altogether.
7.5% is more than double the current FTSE 100 yield, but in today’s market, I think it is a practical goal.
So, does it make sense just to buy high-yield shares to try and earn more passive income?
Not necessarily, given that dividends are never guaranteed to last. A savvy investor needs to understand a company’s finances and commercial prospects, judging what its future dividends may be.
Compounding can be powerful
At a 7.5% yield, a £20k Stocks and Shares ISA ought to generate £1,500 per year of dividends. Over a decade, that would be £15,000.
An alternative would be to compound those dividends. Compounding at 7.5% annually, £20k ought to grow to over £42k.
At a 7.5% yield, that £42k ISA could then generate around £3,168 of dividends annually.
Choosing shares with a long-term mindset
Fees and commissions can add up, so it makes sense to select carefully the most suitable Stocks and Shares ISA.
When looking for shares to buy, I think a long-term approach makes sense.
One dividend share I think investors ought to consider is insurer Aviva (LSE: AV).
Lately, after strong share price growth, it has been trading at levels last seen before the 2008 financial crisis had its full impact.
But does that mean Aviva shares are expensive? Not necessarily, given its strong business performance.
The yield is 5.5% and, since a 2020 dividend cut, the company has grown the payout per share annually.
Aviva is the UK market leader for insurance. It has sharpened its strategic focus on its home market, for example by acquiring rival Direct Line.
That has brought economies of scale, though it also brings the risk that any strong price competition in the UK insurance market could eat badly into Aviva’s profitability.
