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What’s a good passive income target? One gov.uk estimate (from January 2025) puts the average post-tax salary of British workers at £23,184 a year or £1,932 a month. An amount that high would create a second income, the sort that could replace a normal wage and open up the possibilities that come with true financial freedom – early retirement, cutting back on hours or simply a comforting rainy day fund.
One way to build such an income stream is through a Stocks and Shares ISA. The tax benefits in these accounts are generous (you don’t pay any). The returns are as good as the stocks that an investor puts in it. The big question might be… how much do you need in one these ISAs?
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How much?
The simple answer, one might think, is to take a look at what the biggest dividends are and work backwards. Some stocks on the FTSE 250 pay up to 12% yearly. Time to reverse engineer the size of our ISA from that figure? Not so fast.
Even the strongest dividend stocks have a percentage yield that ebbs and flows. One reason is because yield is calculated from the share price. A surging share price means the yield falls and vice versa.
One more issue is that dividends are never guaranteed. Back in 1945, the company formerly known as Royal Dutch Shell started paying a dividend that increased every year for over half a century! But the FTSE 100‘s longest streak came to an end in 2020 when the newly titled Shell announced a cut thanks to the uncertainty of the pandemic.
The typical yearly return target for most ‘high-yield’ investors is 5% or 6%. That means an ISA needs to be £386,400 (at the latter figure) to pay that £23,184 a year amount.
But there is another way…
Dividends
Take a dividend stock like British American Tobacco (LSE: BATS). The cigarette seller may not pay a guaranteed amount every year, but it has an excellent track record. We’re looking at a 5.74% yield at present. And a 10-year dividend growth rate of 4.55% (per year). Throw in over 25 years of dividend increases too.
With a little time to play with, our ‘effective yield’ on the shares can grow much higher. That’s because the increasing dividend, combined with reinvesting the paid dividends, takes advantage of the power of compound interest.
At the current growth rate and reinvesting all dividends received, in 10 years the yield on the original stake would be about 18%. That would mean £128,800 is needed to be put into the ISA for our original goal. That’s not even taking into account a possible rise in share price.
This isn’t to say this kind of plan is without risk. Tobacco is in decline in developed countries. The Maldives just became the first country to introduce a ‘generational ban’ on the stuff. Investors must take this into account before taking the plunge on this kind of stock.
That said, the massive revenues the firm still generates will pay for dividends for many more years, in my view. I think the stock is worth consideration.
