Fancy making a life-changing monthly second income in an ISA? Here’s one strategy I believe you should consider.

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.

Diversifying your ISA

Investing in individual shares is a great way to target long-term wealth. The problem is, even the most reliable dividend share can slash, postpone, or cancel shareholder payouts altogether when times get tough.

The most famous recent example is Shell. In 2020, it cut dividends when the Covid-19 pandemic arrived and oil prices tanked. Why was this shocking? The energy giant hadn’t reduced the yearly dividend since the mid-1940s.

Combating this sort of volatility is essential, and especially if you’re using dividend income to live on. The best way to do this is to create a diversified portfolio — the ‘sweet spot,’ according to many investors and market experts, is one that holds 15 to 20 different shares.

This might be enough to deliver a robust second income in all conditions. But it’s worth remembering almost 500 UK companies cut or delayed or axed dividends during the pandemic, affecting millions of investors relying on dividends.

Here’s the strategy

So how can investors better protect themselves from dividend disappointment? One strategy I use myself is to buy diversified investment trusts and exchange-traded funds (ETFs).

These products often hold a basket of securities covering different asset classes, industries, and regions, allowing investors to spread risk cheaply and quickly. And many of these are designed with passive income in mind, like the Aberdeen Equity Income Trust (LSE: AEI).

This closed-end investment company holds shares in 57 companies, including dividend heavyweights like Legal & General, HSBC, and BP. Roughly 97% of the trust is invested in UK-listed shares, which creates more regional stock market risk for investors. But many of its constituents operate across the globe, protecting earnings and giving it dividend strength.

Indeed, the trust has raised annual dividends for 25 years on the spin, making it one of London’s true dividend kings. Another predicted payout hike in 2026 leaves it with a large 6% dividend yield.

A £10k passive income

With a mixed portfolio of shares, investment trusts, and ETFs, I think a 7% yield is an achievable target. At this rate, a £20,000 Stocks and Shares ISA would deliver a £1,400 passive income in one year.

If an investor can keep this going, and puts £20,000 in their ISA each year with a 9% return, they’d have a £1.7m portfolio after 25 years. They would then earn £120,600 a year in dividends, or £10,050 a month.

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For anyone building wealth over the long term, that’s a powerful advantage. Add to that the ability to choose exactly what goes inside the wrapper – from individual shares to bonds, funds and trusts – and the flexibility becomes clear.

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.

The steady income route

Personally, I think investment trusts can be an underrated way to fill that allowance. They offer a ready-made, professionally-managed portfolio of assets, which means an investor can gain exposure to dozens of companies in one trade. For those leaning towards income generation, dividend-focused investment trusts can provide a reliable stream of cash, often paid quarterly.

With that in mind, I’ve identified two trusts worth considering for an income-focused ISA. While neither excels in capital gains, their strong dividend records and reasonable valuations could form the foundation of a dependable passive income strategy.

Of course, there are trade-offs. While the steady income’s appealing, the underlying capital growth tends to be slower than in pure growth funds. And ongoing management fees, even when modest, will nibble away at returns over time. 

Aberdeen Equity Income Trust

Aberdeen Equity Income Trust‘s (LSE: AEI) a closed-end investment company that holds between 50 and 70 UK shares. These include big names like Imperial Brands, HSBC, BP and Berkeley Group.

Its portfolio’s nicely spread across sectors, with 42% in financials, 16% in industrials, 14% in energy and 9% in consumer staples. That sector diversity helps balance risk, though its UK-only focus could limit returns if the domestic economy stumbles.

The trust has a market-cap of £178.9m, which means it can be more volatile than larger funds. The share price has only risen around 37% over the past five years, but income investors may forgive that given the 14 consecutive years of dividend growth. 

The yield sits at an impressive 6.2%, with a payout ratio of just 54.39%, suggesting the payments are well covered. Valuation looks appealing, with a price-to-earnings (P/E) ratio of 8.8 and the shares trading at a slight 1.8% discount to net asset value.

Schroder Income Growth Fund

Schroder Income Growth Fund (LSE: SCF) takes a similarly UK-centric approach, investing in household names such as AstraZeneca, HSBC, Shell, Lloyds and National Grid. Around 30% of its holdings are in defensive sectors, 45% in cyclical industries, and 23% in economically sensitive areas.

With 98% of its assets in the UK, it also faces geographical concentration risk, leaving it exposed to domestic downturns. Still, the income track record’s hard to ignore — more than two decades of continuous dividend growth. The current yield’s 5.16%, supported by a very conservative payout ratio of 27.42%. 

With a P/E ratio of just 6, it appears undervalued and attractive, while the £221.37m market-cap provides a little more stability than some smaller trusts. The share price has grown about 30% in five years, making it more of a steady plodder than a high-flyer.

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Making use of the ISA

To begin with, the ISA needs to be set up. It’s possible to build a second income without one, but holding the stocks within this investment account is more tax efficient. When an investor receives a dividend or sells a stock for a profit, the proceeds aren’t subject to tax in the ISA. This means that more of the money can be retained, thus accelerating the process of building the portfolio.

In terms of funding the account, there’s a limit of £20k a year that can be invested in an ISA. Some might find it easier on cash flow to invest an amount each month, rather than adding £20k once a year. Of course, no one’s forced to invest £20k. But the closer an investor can get to this figure helps to speed up the process.

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.

Dividend stock picks

With the money ready to be deployed, the focus now turns to picking good dividend stocks. As a note, picking the stock with the highest yield isn’t always the best one. A high yield could be due to the share price falling, meaning that the dividend might not be sustainable.

Rather, considering a slightly lower-yielding option can be more realistic. For example, the abrdn Equity Income Trust (LSE:AEI). The investment trust has a dividend yield of 7.25%, with the share price up 5% over the last year.

The investment manager (abrdn) aims to provide a high income level by selecting a host of different stocks that pay dividends. It’s a nice option to consider as it takes a lot of the legwork out of researching individual ideas, as well as reducing hassle and transaction costs from buying all the stocks individually.

At the moment, the company has most of the exposure to UK shares. The largest weighting is to financial services with 43%, followed by energy at 18%. The biggest individual holding is Imperial Brands.

One risk here is that it’s an all-or-nothing-style trust. If an investor doesn’t like some of the holdings, they can’t pick and choose what the investment manager includes in the trust.

Reaching the goal

To make £650 a month, it’s not something that will happen overnight. Assuming that an investor can invest £20k a year with a portfolio of stocks that have an average yield of 7%, I can work out some forecasts.

After four years, the investment pot could be worth £115.5k. This could mean in the following year, it could generate a second income of £674 a month.

If an investor put in less per month, the time frame would become longer to hit the goal. Of course, these are just forecasts and should be taken with a pinch of salt, but it shows the potential!

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There are some great income-generating trusts out there. I’ve repeatedly highlighted UK equity income favourites like City of London Investment Trust, which currently yields 4.7%, and Merchants Trust, which yields 4.6%.

These offer terrific yields

Yet a handful offer even higher yields, which would allow me to generate more passive income from this year’s £20,000 Stocks and Shares ISA contribution limit. 

I held one of these trusts about 15 years ago, from the days before I understood the merits of long-term buy-and-hold investing. It’s Henderson Far East Income (LSE: HFEL) and currently yields a thumping 9.1% a year from a portfolio of shares from the Asia-Pacific region, including Australia, China, South Korea, Singapore, Hong Kong and Taiwan.

Top holdings include include big names BHP Group, Macquarie Group, Samsung Electronics, Rio Tinto and Taiwan Semiconductor Manufacturing.

Henderson Far East Income was launched way back in 1930 and manages assets totalling £408m. It’s in demand and currently trades at a premium of 2.5% to net asset value.

It aims to offer capital appreciation as well as income, although it hasn’t done as well on this front. The share price is down 4.8% over the last year, and is up just 4.6% over five years. That’s disappointing, given that its benchmark index, Asia-Pacific Equity Income, is up 29.3% over the same period.

Henderson Far East Income prioritises income over growth, and on that front it delivers. While Asia-Pacific markets can be volatile, this trust nicely balances my FTSE 100 holdings.

I’m also intrigued by the abrdn Equity Income Trust (LSE: AEI), because its yield of 6.8% is notably higher than most UK funds. Yet there are some really impressive dividends on the FTSE 100 today, with a dozen stocks yielding between 7% and 10%.

Some familiar names here

The fund’s top holdings include FTSE 100 favourites BP, Shell, NatWest, SSE, National Grid, Imperial Brands, Barclays and Glencore. I’d happily hold any of those directly. But with this fund I get exposure to all of them in one go.

Abrdn Equity Income Trust was launched in 2005 and is worth around £160m. The share price is down 3.1% over the last turbulent year year, and is down 2.9% over five years. Again, that’s well below its benchmark IT UK equity income index, which grew 21.5%. I guess that’s the trade-off for higher income (it’s up 47.3% over three years though). This trust is also in demand, trading at a tiny discount of -0.5% to its underlying net asset value.

If I split a £20,000 ISA allowance between these two trusts, I’d get income of £910 a year from Henderson Far East Income and £680 from Abrdn Equity Income Trust.

My total annual income would be £1,590 in the first year. While dividend income is never guaranteed, that’s still impressive. Also, an investment trust reduces the danger by spreading risk across dozens of stocks. I’ve added both to my buy list and will snap them if they dip at any point, so I can pick them up at a discount.

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