With a long-term perspective on financial planning, I think using my Stocks and Shares ISA in the right way could help me build wealth in the coming decades. For example, if I wanted to target a second income of £10,000 per year, I think I could work towards it by investing my ISA in the right way.
Compounding
Key to this is the idea of compounding.
Imagine pushing a snowball down a hill. As it moves, it picks up snow, which in turn picks up more snow. So it does not get bigger at a uniform rate. The more it grows, the faster it keeps growing.
A less charming example is an unpaid credit card bill. Over time, such a bill can balloon because the unpaid interest also starts generating more interest to be paid.
Financially though, the principle of compounding does not have to work against me.
I could use it to my advantage when it comes to a Stocks and Shares ISA. If I let gains in the ISA compound over the course of years rather than pull them out as cash, I could see my long-term returns get bigger.
Interest and capital gains
As an example, consider dividends.
If my £20,000 ISA was invested at an average yield of 7%, I would earn £1,400 annually in dividends. But if I let those dividends compound, after a decade I would be earning £2,754 each year in dividends.
It is not just interest that can compound. My capital gains could compound. If I invest in shares that rise in value and later sell them, I will have more money to invest than I started with.
So in my ISA I hold both income shares like British American Tobacco and growth picks such as Alphabet.
If I compound my £20,000 initial investment at an average annual rate of 8%, after 24 years I will have a portfolio worth over £125,000.
Setting up the second income
If I could generate an 8% dividend yield on that amount, I would hit my target of earning £10,000 each year from my ISA in dividends.
But, to generate that second income, I need a yield of 8%. That is not necessarily the same as a compound annual gain of 8%. In my example above, compounding capital gains helped me grow the size of my ISA. But turning that into a regular dividend income would require me to own shares that pay dividends.
I do not need to do that at first. But once I want to draw my second income, I would load up the ISA with dividend shares.
In my example I use 8%, fairly high for a dividend yield. But I think it is achievable even when sticking to blue-chip shares. British American Tobacco, for example, currently has an 8.2% yield.
Investing for the long term and buying into quality companies at the right price could help me earn a five-figure sum far into the future.
The post How to turn an ISA into a £10K second income appeared first on The Motley Fool UK.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. C Ruane has positions in Alphabet and British American Tobacco P.l.c. The Motley Fool UK has recommended Alphabet and British American Tobacco P.l.c. 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.