One of the things I like about owning dividend shares in my ISA is the dividend income I can earn. That can come in handy as a passive income source. But I could also reinvest those dividends (something known as compounding) to try and boost my long-term returns.
By doing that, I reckon I could try and use a £20K ISA to generate £2,000 annually in dividends over the next six years. Here’s how.
Above-average yields from quality companies
Imagine I invest the £20K ISA at an average yield of 7% and reinvest. Ignoring the impact of share price changes (that could work in my favour, or against), a compound annual gain of 7% would mean that after six years, my 7%-yielding ISA should be large enough to generate over £2,000 in dividends annually.
At that point, instead of continuing to compound dividends, I could start taking them out as passive income streams.
7% is well above average for a blue-chip FTSE 100 company. The average FTSE 100 firm currently yields 3.6%.
Still, that is only an average. Some shares offer more including what I see as excellent businesses with strong income generation potential.
Finding shares to buy
Diversification is an important risk management strategy. With a £20K ISA, I would aim to spread my money over five to 10 different shares.
To illustrate the sort of shares I think investors should consider buying, I will zoom in on two.
One of them is Legal & General (LSE: LGEN).
The FTSE 100 company has a track record of raising its annual dividend frequently. It is aiming annual growth in the dividend per share of 2% over the next few years and already yields a juicy 8.9%.
Still, no dividend is ever guaranteed. Legal & General cut its payout in the last financial crisis and I see a risk the same could happen the next time markets crash if policyholders get nervous and valuations in the firm’s investment portfolio suddenly fall.
Still, I like the company’s focus on retirement-linked investment products. It is a large market and one I expect to remain that way. Thanks to its focus, industry expertise and iconic umbrella brand, Legal & General looks well-positioned to benefit from it.
Beyond the FTSE 100
As I said, I like to invest in proven, large businesses. But I do also consider smaller and medium-sized companies, including in the FTSE 250 index.
For example, one FTSE 250 share I think income-focussed investors should consider for their ISA is household name ITV (LSE: ITV).
Its current yield of 6.7% is slightly below the target I mentioned above, but as that is an average it could still be hit owning the right mixture of shares yielding over and under 7%.
ITV management aims to maintain the annual dividend per share. But after falling 51% in five years, the ITV share price suggests the City has its doubts.
One risk is an ever-expanding universe of digital competitors pulling away ITV’s traditional audience.
Still, such competition might actually help ITV’s division that leases studio spaces and offers production assistance.
Meanwhile, it is expanding its own digital footprint and continues to operate a significant legacy business.
