Image source: Getty Images
Earning a second income from dividends is a simple but potentially powerful way for someone to supplement their main income. Here is how a £20k Stocks and Shares ISA could generate a £1,600 annual second income.
The first move, of course, would be to choose a Stocks and Shares ISA to put the £20k into. There are lots of options available, so an investor ought to spend some time deciding which one best suits their own needs.
Building a savvy income portfolio
Earning £1,600 from a £20k ISA requires a dividend yield of 8%.
One approach could be simply to put the money into an 8%-yielding share. But there are a couple of big risks doing that, as I see it. The lack of diversification adds unnecessary risk – for example, if that company goes bankrupt, the entire ISA could end up worthless.
Also, dividends are never guaranteed, so investing solely based on yield seems unwise to me. I think it is important to understand how a business works, so an investor can make a judgement about how likely it seems in future to throw off excess cash flows that can be used to fund dividends.
Bearing that in mind, an investor might want to spread the £20k ISA across five to 10 different shares.
Finding shares to buy
The 8% figure is an ambitious target for dividend yield, if sticking to quality blue-chip companies with proven business models. It is over double the current FTSE 100 yield. It is possible in today’s market though.
One share I think investors ought to consider is FTSE 100 financial services firm Legal & General (LSE: LGEN). It focuses on retirement-linked products. That is a large, resilient and potentially very lucrative market. Thanks to its iconic brand and umbrella logo, deep experience, large customer base and proven model, Legal & General is able to perform well even though it faces many rivals.
The planned sale of a US business will give its coffers a short-term boost, although I see a risk that it will reduce the business’s overall profit level, potentially making it harder to keep growing the dividend per share by 2% annually as it is currently doing.
Getting passive income from blue-chip shares
One of the benefits of earning a second income from an ISA could be that the money comes tax-free, depending on the investor’s individual situation.
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.
That could be withdrawn regularly. However, an alternative exists: leave the dividends in the ISA so they can be used to buy more shares. That is known as compounding and is a powerful technique to build wealth.
Compounding a £20k ISA at 8% annually for a decade, for example, would mean that 10 years from now it will be worth over £43k. At an 8% yield, that would produce an annual second income of over £3,450.
