Many Britons invest for passive income. And in the cost-of-living crisis, that passive income could be more important than ever.
Of course, if I had £20,000 — the maximum annual ISA contribution limit — I could invest in stocks and shares now and look to achieve an 8% return in the form of dividends. That’s around £1,600 a year. This is a decent figure, but over time, I’m going to need more — especially if inflation remains elevated.
For me, 8% is pretty much the most I could achieve without compromising the sustainability of the dividend. But with these stocks, many of them financials, I wouldn’t expect too much in the way of share price growth.
So, how could I turn a £20k ISA into a handsome, lifelong passive income? Let’s take a closer look.
Compound returns
First, I’m looking at a strategy to grow my £20k ISA. A compound returns strategy involves reinvesting my dividends and earning interest on my interest. Essentially, it’s very much like a snowball effect.
So, let’s imagine I invest my £20,000 into stocks paying an 8% dividend on average. And instead of taking that dividend every year, I reinvest that money for a period of 10 years. Well, after 10 years, my £20,000 would be worth £44,500.
In fact, the longer I leave it, the more I’d have. The growth is exponential. After 30 years, the figure would be £212,000. That’s a huge amount of growth.
I could also enhance this my investing regularly. If I added just £200 a month and increased my contributions by 5% every year, after 30 years, I’d have £718,000.
However, let’s imagine I’m only reinvesting my returns for 10 years, but I’m going to be contributing £200 a month, and every year I’m going to increase that contribution by 5%. After 10 years, I’d have £88,900.
And, with £88,900 I could realistically look to achieve around £7,100 a year by investing in dividend stocks with 8% yields. That’s a decent return and considerably larger than what I could achieve now.
But of course, I know that my stock picks could underperform so nothing is guaranteed.
Picking stocks
Ok, so looking on the bright side, how do I get there? The strategy sounds great but I need to pick the right stocks. I need to invest in sustainable yields, and as I’ve noted, I think 8% is pretty much the highest I can achieve.
One way to tell if a company has a sustainable dividend yield is by using the dividend coverage ratio (DCR). This metric shows me how many times a company can pay its dividends from its earnings over a year.
A DCR of two and above is generally considered healthy. However, it’s worth noting that companies with lower DCR, but strong cash flows, can have healthy yields.
And what stocks would I pick? Well, there are a handful of companies that I like. Many of which, such as Phoenix Group, Legal & General, and Aviva, I’ve already added to my portfolio. These stocks have an 8.8%, 8.4% and 7.5% yield, respectively.
The post How I’d aim to turn a £20k ISA into lifelong passive income! appeared first on The Motley Fool UK.
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James Fox has positions in Aviva Plc, Legal & General Group Plc, and Phoenix Group Holdings Plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.