With volatility still plaguing the markets, it’s a terrific time to start making use of the benefits of a Stocks and Shares ISA. Tax-free capital gains and dividends pave the way for some wonderful wealth-building. And when executed correctly, it’s possible to use the £20,000 annual contribution limit to establish a £2,000 passive income stream. Here’s how.
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.
Targeting 10%
If I want to have £2,000 flowing into my bank account each year from a £20k investment, I’m looking for a 10% annual return. That’s roughly in line with what the stock market has traditionally achieved. The FTSE 100 typically offers around 8% gains, while the FTSE 250 is closer to 11%, albeit with far greater volatility.
But these returns are a combination of share price appreciation and dividends. What if I only wanted to build this income stream with dividends alone?
Valuations are in the gutter thanks to stubborn inflation and rising interest rates. However, that’s also helped push dividend yields to some of the highest levels I’ve seen in years. In fact, looking at the FTSE 350, there are just shy of 20 companies offering payouts of 10% or more.
While that’s plenty to diversify a portfolio, allocating all my capital to these firms is likely to backfire spectacularly. Double-digit yields are rarely sustainable, and investors lured by these potential traps could see dividends being cut, sending the stock price crashing in the process.
So remember, 10% is the goal, not the starting point. Therefore, it’s far more prudent and lucrative to find income-generating businesses capable of growing their dividend payout over time. This isn’t only more sustainable but can lead to far more impressive yields on an initial investment in the long run.
One example from my income portfolio is Safestore. In 2016, shares of the self-storage provider came with a 3.3% yield. Since then, dividends have almost tripled, pushing the yield into double-digit territory.
Managing risk
Identifying companies that can systematically and meaningfully increase their payouts is easier said than done. But cash-generative enterprises are often an excellent starting point for finding these opportunities. However, that doesn’t make them a risk-free endeavour.
If the last few years have taught investors anything, it’s that cash flows can be disrupted. All it takes is one unforeseen external event like a global pandemic or economic instability to throw a spanner in the works. And even one of the best income stocks today might be forced to hit pause on its dividends. Needless to say, that’s bad news for an income-oriented ISA.
Risk is an unavoidable part of any investment portfolio. But as previously mentioned, diversification is a terrific tool for keeping things in check. By owning a range of top-notch businesses in different industries, the impact of another sudden disruption can be mitigated.
