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Earning a passive income without lifting a finger sounds like a dream, but it’s achievable.
Better still, it can be generated entirely tax-free inside a Stocks and Shares ISA, using the £20,000 annual contribution limit available to every UK adult. Investors can enjoy a second income for life without paying a penny in income tax or dividend tax. Capital gains are tax-free too.
Most people favour the perceived safety of a Cash ISA, something Chancellor Rachel Reeves hopes to change. But while cash feels lower-risk, a Stocks and Shares ISA has far greater long-term potential to build wealth and generate income.
Tax-free returns
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.
Over the long run, the stock market has comfortably outperformed savings accounts and bonds, although it is more volatile. Investors can limit their risk by holding a diversified basket of shares, ideally for many years or even decades. A separate cash buffer is useful for emergencies, leaving investments to grow undisturbed.
So how much would an investor need to generate a passive income of £1,500 a month, or £18,000 a year?
The 4% rule
According to the 4% rule, which measures the supposed safe withdrawal rate from a pension pot, taking 4% each year should allow the capital to last for life. On that basis, our investor would need a portfolio of £450,000 to generate £18,000 annually.
That’s not a small sum, but it’s achievable with time, consistency and the power of compounding. Over the long term, the FTSE 100 has delivered average annual returns of around 8%. Investing £500 a month at that rate could grow to £473,726 after 25 years.
Yes, 25 years is a long time, but that’s still two decades less than the average working life. And the sooner investors start, the easier it gets. Even if they fall short of that target, they will still generate far more wealth than if they never tried.
British American Tobacco grows
Some individual stocks may deliver faster progress. British American Tobacco (LSE: BATS) is a FTSE 100 dividend machine with a consistent and lengthy track record of raising shareholder payouts. It currently yields 6% and its share price is up 44% over the past 12 months. That pace may not continue, but the shares still look good value on a price-to-earnings ratio of 10.7.
There are risks. Tobacco is a shrinking, heavily regulated industry. But British American is pivoting to reduced-risk products such as smokeless cigarettes, offering new long-term potential. This is a stock to consider for patient investors seeking long-term income, not a quick profit.
I’d look to build a portfolio of at least 15 stocks across different sectors and income profiles. Not every pick will beat the market, but in my experience, thoughtful stock-picking can deliver a more rewarding and higher-yielding ISA over time. And that will hopefully mean more passive income at the end of it.
