There are several ways to invest for a second income, ranging from peer-to-peer lending to buy-to-let properties. Each strategy has potential risks and rewards. Regarding my own investments, I choose to buy dividend shares in a Stocks and Shares ISA.
With a £20k annual allowance on offer, the ability to invest small regular sums, and tax-free treatment on capital gains and dividends, I think an ISA is an excellent vehicle for me to use in pursuit of my passive income goals. So, here’s how I’d aim for £30k in annual dividend payments starting from scratch.
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.
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Tax-free investing
Perhaps the most significant advantage of ISA investing is not needing to worry about HMRC. Tax optimisation is a key consideration for investors and, under the current rules, investments sheltered within the ISA wrapper don’t attract tax in perpetuity.
Viewed through this prism, using an ISA has considerable benefits compared to other methods of investing for a second income. For instance, buy-to-let properties have various tax implications.
Plus, being a landlord is less passive than owning a dividend portfolio. Ideally, I’m looking for a relatively hands-off approach to my investments. An ISA offers this.
Targeting £30k in dividends
So, is it possible to secure £30k in annual dividends starting with zero? Yes, I believe so — but it won’t happen overnight.
I’m a long-term investor. My second income goal is a long-term aspiration. That’s because time is arguably my greatest ally in achieving good returns. Not only does a long investment horizon help to mitigate risks posed by short-term volatility, but it also allows me to harness the power of compound returns.
To illustrate this, imagine I could afford to invest £20 a day and my portfolio grew at an 8% compound annual rate from capital gains and dividend reinvestments. That’s similar to the FTSE 100‘s historic average over long time periods.
If I secured a 4% yield across my stock market holdings, I’d need a portfolio worth £750k. On my modelling assumptions, I’d earn £30k in annual dividend income in less than 28 years.
To achieve this, there are many Footsie dividend stocks I could invest in. Some good examples include:
| FTSE 100 stock | Dividend yield |
|---|---|
| Barclays | 4.4% |
| Glencore | 7.2% |
| Legal & General | 8.3% |
| National Grid | 5.2% |
| Unilever | 3.7% |
Risk and reward
Although dividend investing has significant potential rewards, there are possible pitfalls too. Companies can cut or suspend dividend payments. The stock market may deliver lower future returns than it has done in the past. The tax-free ISA rules could change.
All of these factors would affect my neat calculations, potentially requiring higher contributions to meet my £30k tax-free income target or a longer time horizon to allow my investments to compound further.
However, by diversifying my positions across different companies and sectors, I won’t be overly exposed to any single business. And, I’m generally optimistic about the stock market’s future. After all, it’s likely firms will continue to innovate and grow.
If I avoided dividend stocks altogether for fear of the future, I’d miss out on potentially significant rewards. I’m not going to pass on that opportunity, so I’d strive to invest as much as I can afford in an ISA as soon as possible.
