The Stocks and Shares ISA is one of the greatest inventions ever. Of course, as an ISA investor trying to build long-term wealth for retirement, I’m biased. I would say that.
However, beyond building future wealth, it’s also a fantastic account for passive income. What’s more, this income is totally tax-free, making the Stocks and Shares ISA a no-brainer for someone just starting their investing journey.
But how much passive income could realistically be expected from an ISA every year?
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.
Diversification
The first thing to mention is that individual dividends are never guaranteed. Even the seemingly most secure income-paying companies can shock shareholders with a dividend cut.
For example, Tesco axed its payout around a decade ago after an accounting scandal. Banks also tend to pull up the dividend drawbridge whenever a crisis engulfs the financial system.
So what can be done about this? The solution to this is to build a diversified portfolio of, say, 10-25 dividend stocks. This way, if one or two stocks stop paying out, the rest of the portfolio should ideally pick up the slack. Passive income should still flow.
Long-term thinking
Of course, most people don’t have the cash to immediately build a 20-stock portfolio. Using up the full current annual ISA allowance, that would mean investing £20k.
The good news is that a successful income portfolio can be built over time. For instance, by investing £550 each month, it would take roughly three years to reach £20,000, excluding any returns and fees.
Were the stocks in the portfolio to yield 5% on average, they would already be paying £1,000 a year in tax-free passive income. Not bad.
Continue this monthly routine however, and the ISA would grow to £147,000 after 15 years, assuming dividends are reinvested rather than spent. By this point, it would be generating £7,350 (the equivalent of around £141 a week in dividends).
Remember, this scenario assumes no capital growth from the stocks in the portfolio. Ideally, it should increase in value over time, as should most of the annual dividends paid by the holdings. Not all, of course, as returns are never guaranteed. But ideally most.
In other words, a high-quality portfolio by that point should be worth more than £147k and be yielding above 5%. A seasoned stock investor should be able to identify and capitalise upon long-term opportunities, especially when markets crash.
Income ETF
There are many blue-chip UK stocks offering high dividend yields today, including Legal & General (8.5%), Standard Life (7.8%), Londonmetric Property (6.7%), and British American Tobacco (5.7%).
However, for investors who don’t feel confident picking individual shares, I think iShares UK Dividend ETF (LSE:IUKD) is worth a look. This exchange-traded fund (ETF) holds 50 UK income stocks with high yields.
Holdings include the stocks mentioned above, as well as the likes of BP, Shell, Admiral, and mining giant Rio Tinto. The ETF’s yield is 4.7%, which is higher than the FTSE 100’s 3.05%.
The biggest risk with this ETF is a potential global economic downturn, as most FTSE 100 giants operate worldwide. In this scenario, some dividends could be cut, in turn reducing the fund’s yield.
On balance however, I see the ETF as a solid choice to consider, especially for new passive income investors.
