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Investors looking to build a passive income for retirement have two tax-efficient ways of doing it, either an ISA or a Self-Invested Personal Pension (SIPP). Both offer complementary tax benefits and can work nicely in tandem.
Money invested in a Stocks and Shares ISA rolls up free of income tax, dividend tax and capital gains tax, and can be withdrawn entirely tax free. SIPPs offer upfront tax relief on contributions, which means every £100 paid in only costs a higher-rate taxpayer £60. Inside the wrapper, dividend income and capital gains are sheltered, while 25% of the pot can usually be taken tax free. Further withdrawals are taxed as income.
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.
Setting a retirement target
I’ll start with the number in the headline. A £2,500 monthly income works out at £30,000 a year. A common rule of thumb is the 4% ‘safe withdrawal rate’. It suggests that drawing 4% a year should help preserve the underlying capital. On that basis, £30,000 would require a fund worth about £750,000. An investor who generated a 5% yield from a portfolio of dividend-paying FTSE 100 shares could earn the same income from a pot of £600,000.
These are big sums, but regular investing and long-term returns can turn steady contributions into something substantial.
Let’s take the example of a 30 year-old who’s already got £20,000 saved, either in an ISA or SIPP. If they invest £300 a month and achieve an average 7% annual return from FTSE shares, they’d have £746,000 by age 65. Remember, if they’re a 40% rate taxpayer, £300 paid into a SIPP only costs £180 after tax relief.
I run my own SIPP with a spread of income-focused shares and funds. Most hail from the FTSE 100, plus a few from the FTSE 250, and I aim to blend dividends with long-term growth.
Tempting FTSE 100 dividend stock
Housebuilding stocks intrigue me right now. To take one example, FTSE 100-listed Barratt Redrow (LSE: BTRW) has struggled, its shares falling 18% over the last year and 42% over five years. Brexit hit confidence across the board, the end of Help to Buy scheme in 2023 removed vital government support for buyers, and high inflation has pushed up mortgage rates.
That could change. On Thursday (18 December), the Bank of England is expected to cut base rates again, from 4% to 3.75%. Further cuts are expected next year, which could revive demand.
Nothing is guaranteed. Employment is rising and property affordability remains stretched. Still, Barratt Redrow reflects these risks, trading on a modest price-to-earnings ratio of 14 and offers a tempting 4.9% yield. I think it’s worth considering for investors who understand the risks, with a long-term view to allow those dividends to compound.
The key to building a successful portfolio is to target around 15 stocks with different risk profiles, and staying invested for the long-term, to give the income and growth time to compound. The FTSE is full of exciting shares to consider today. The sooner investors start, the longer their money has to compound and grow.
