When it comes to earning passive income, stuffing a Stocks and Shares ISA with dividend shares has the benefit of simplicity and – potentially – being a lucrative approach.
How does it work in action? Let me illustrate by walking through an example…
Step one: setting a target
To begin, I will set a target: a monthly average passive income of £1,000.
The same approach could work with a higher or lower target. There will be a corresponding impact on timeline and/or how much the investor needs to contribute.
Step two: starting regular contributions
For this example, I will presume an average dividend yield of 5%. That is well above the current FTSE 100 average of 3% but still achievable in today’s market while sticking to quality blue-chip shares, in my opinion.
Hitting the target at that yield would require a Stocks and Shares ISA worth £240k.
Most people do not have an ISA with that much money sitting idly in it. But it is possible to build to it over time, even starting from scratch with a brand new, empty Stocks and Shares ISA.
One way to do that would be to reinvest dividends initially, something known as compounding. Putting in £20k a year and compounding it at 5% annually, the ISA would be worth over £240k after a decade. At that point, dividends could start being withdrawn as passive income.
Step three: building a share portfolio
With money in the ISA, someone can now start buying shares. But before doing that, they ought to get to grips at least with the basics of stock market investing, such as valuation and understanding why free cash flows matter when it comes to paying dividends.
One share I think is worth considering right now for its dividend potential is FTSE 100 asset manager M&G (LSE: MNG). Its 6% yield is twice the index average mentioned above. The payout could keep growing as M&G aims to increase its dividend per share annually.
With a customer base in the millions spread over multiple markets, a strong brand and long financial markets expertise, I think M&G has the potential to keep doing well.
One risk I see though, is that choppy financial markets could lead policyholders to pull out more money than they add. M&G has struggled with that in the past.
Positively, its most recent trading statement showed that in the first quarter of this year, it saw a net inflow of funds into the part of its business that is still open to new investment. I will be keeping my eye on this important performance indicator.
Step four: letting the income flow!
As I outlined above, although dividends could flow within months, under this plan they are initially re-invested, so the investor will not get them as passive income until a decade has passed.
But it is up to them. The passive income could flow much sooner if they choose, just at a lower level than if they are patient and take the long-term approach to contributing regularly and compounding.
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Christopher Ruane does not hold any positions in the companies mentioned.
