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An ISA can be used to earn a passive income, simply by using it to hold some shares that pay dividends.
Sound simple? It can be – but how much passive income might such an approach generate?
ISA size, yield, and timeframe
That depends on three key elements.
First, how much money is in the ISA? Secondly, what is its average yield? That may move up or down over time even without changing the shares owned, as dividends can move up and down.
The third factor is the timeframe concerned.
Aiming for £500 a month
Let me bring that to life with an example.
Say someone wants to target £500 of passive income per month, on average. That adds up to £6,000 per year.
For the sake of example, I will use a 6% dividend yield. That is over double the current FTSE 100 yield of 2.9%, but in the current market I think it is achievable while sticking to high-quality companies.
At 6%, a £6k annual passive income would require an ISA of £100k.
Taking a longer-term view
But an alternative could be to drip feed money in over time.
Say the investor put in £100 a week and, instead of taking the dividends out, reinvested them – this is known as compounding.
Putting £100 a week into an empty ISA and compounding it at 6% annually, it ought to be worth over £100k after 13 years. At that point, a 6% dividend yield could produce the passive income target I am using as an example.
Choosing the right ISA can help!
One thing that can eat into returns is stockbroking commissions, fees, and other charges.
So it makes sense to spend some time hunting around for the best Stocks and Shares ISA.
Each person will have their own criteria. Fortunately, there are lots of different Stocks and Shares ISAs available.
Hunting for quality dividend shares
As a long-term investor I like to find blue-chip shares with proven business models that I can tuck away in my ISA and then hold for years.
One share I think investors should consider is FTSE 100 insurer Aviva (LSE: AV).
Its 5.7% yield is already close to the 6% I mentioned above. I think it can keep growing as it has done in recent years, potentially pushing the prospective yield up.
That is not guaranteed, of course: Aviva had a painful dividend cut in 2020.
Aviva is the country’s biggest insurer, so one risk I see is smaller rivals trying to get some of its market share by competing on price, pushing down profit margins across the industry.
But I also see that market leadership as a source of strength.
It gives Aviva economies of scale, thanks to a huge client base.
Plus, it enables the company to try and sell more than one service or product to a customer. That strategy has been working well for Aviva.
