The Stocks and Shares ISA‘s a great vehicle for generating passive income. With an annual contribution limit of £20,000, access to dividend stocks and income funds, no tax on income (or gains), and the flexibility to withdraw capital any time, it’s a truly brilliant set-up.
Wondering how much income an investor could potentially generate with this kind of ISA? Let’s explore some scenarios involving a £20,000 investment.
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.
A lower-risk income strategy
There are several different ways to generate passive income within an ISA. Each approach has a different level of risk. A lower-risk strategy (but still higher risk than investing in cash savings products) is to invest in an income-focused fund, exchange-traded fund (ETF), or investment trust. These products generally provide exposure to many different dividend stocks, significantly lowering stock-specific risk for investors.
The dividend yields on these products vary. Some aren’t much higher than the interest rates offered on savings accounts however, others are a bit higher.
One product with quite a high yield at the moment is the Merchants Trust (LSE: MRCH), an investment trust that’s focused on income stocks. For the 2024 financial year, it rewarded investors with dividend income of 29.1p per share.
Given that its current share price is 558p that puts the trailing yield at 5.2%. If someone was to put their whole £20,000 ISA allowance into this product (which I’d never do as diversification’s crucial), that would result in annual income of around £1,040.
Now, this product has its advantages. One is that it pays dividends on a quarterly basis – this is handy for those looking to obtain regular cash flow. Another is that it regularly increases its payout — it’s done so for 43 consecutive years now.
It’s also provided long-term capital gains. Over the last 10 years, the share price has climbed about 27%, which translates to annualised gains of about 2.5% a year.
Given these advantages, it could be worth considering. However, I wouldn’t go ‘all-in’ on it. At times, this trust has produced underwhelming returns due to the portfolio mix (generally ‘old-economy’ stocks). And it could be possible to obtain higher total returns (income plus gains) elsewhere.
Targeting higher levels of cash flow
Another strategy is investing directly in dividend stocks. This is higher risk but there’s potential for higher returns (risk and potential returns are directly related in the investing world).
On the London Stock Exchange today, there are plenty of stocks with yields in excess of 7%. Some examples include Legal & General Group, Phoenix Group, M&G, Primary Health Properties, and Renewables Infrastructure.
So let’s say an investor bought 10 different high-yield stocks (£2k in each, ignoring trading commissions) and the average yield on the portfolio was 7.5%.
In this scenario, the investor would be looking at annual income of around £1,500. That’s a decent level of income (and quite a bit more than can be obtained from cash savings).
Now, investors do need to be careful with this approach. Because dividends are never guaranteed and a high yield on a stock often signals that there are problems with the underlying business (and that a cut may be coming).
The strategy’s definitely worth considering though. If you’re looking for dividend stock ideas, you can find plenty right here at The Motley Fool.
