Building a steady passive income from stocks isnât just wishful thinking. Many ordinary people are achieving it, and they donât need to be investment geniuses to succeed. Iâm certainly not, but Iâm doing okay.
Those starting afresh with a Stocks and Shares ISA may be surprised to discover how much passive income they generate if they really go for it.
By my calculations, an investor could potentially earn a massive second income of £17,640 a year in just a decade if they consistently max out their annual £20,000 allowance.
Investing for tax-free returns
Investors donât have to draw this income straight away. Ideally, they should reinvest it straight back into their portfolio to buy more shares.
This creates a compounding effect, resulting in even higher dividends over time, which can deliver an even higher passive income stream when they finally retire.
The first step is opening an ISA. While itâs possible to invest without one, any dividends earned or capital gains made within the tax-free ISA wrapper are exempt from income and capital gains tax for life.
This ensures more money remains invested, accelerating portfolio growth.
While not all investors can contribute the maximum £20,000 (I certainly canât), paying in as much as possible â whether through regular monthly payments or one-off sums â can make a significant difference.
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.
Diversificationâs vital
After setting up the ISA, the next step is choosing a diversified spread of dividend-paying stocks. Income-focused investment trusts or funds can also provide diversification and simplicity, but I prefer buying individual stocks.
Some can generate spectacular yields. FTSE 100 fund manager M&G (LSE: MNG), which I hold, is renowned for its high dividend payouts, currently offering a trailing yield of 9.67%.
While high yields arenât always sustainable, M&Gâs history of returning cash to shareholders gives me confidence that this one can endure.
M&G benefits from a strong brand, diversified products and steady fee income from asset management and insurance services. However, its share price has performed poorly, falling 8% over the past year and 17% over five years.
M&Gâs one of my favourite dividend payers
This slump is partly due to wider stock market volatility, which has hurt customer inflows. The asset management industry also faces stiff competition from low-cost alternatives like exchange-traded funds (ETFs).
That said, I expect M&Gâs share price to recover strongly once inflation and interest rates fall. While I wait, I’m reinvesting every dividend to build my position, optimistic about its long-term potential.
With £20,000 invested annually, an investor could build a diversified portfolio of a dozen-or-so income stocks to spread their risk.
Assuming a return of 6.9% annually (in line with the FTSE 100âs long-term average), this portfolio could grow to £294,000 after 10 years.
With an average yield of 6% it could generate £17,640 of passive income a year, while leaving the capital invested to grow (and earn still more dividends). None of this is guaranteed, of course. Nothing is when buying shares.
Even smaller sums, like £2,000 or £5,000 annually, can yield outsize returns. The key is consistency, discipline and a long-term outlook. The more investors put in, they more they should get out.
The post Investing £20,000 annually in an ISA could generate a £17,640 passive income in 10 years appeared first on The Motley Fool UK.
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Harvey Jones has positions in M&G Plc. The Motley Fool UK has recommended M&G Plc. 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.
