How to turn a 20k ISA into a £12,805 yearly second income! (2024)

UK residents can take advantage of the tax-efficient ISA wrapper to earn a sizeable second income. Dr James Fox explains how it’s possible.

The content of this article was relevant at the time of publishing. Circ*mstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Dividends can make an excellent second income. Instead of investing in buy-to-let projects or getting a second job, for me, this is the most time efficient and financially rewarding.

Recent surges in inflation underscore the significance of ensuring that income, at the very least, keeps up with the escalating costs of living.

The plan for a second income

The Stocks and Shares ISA allows UK residents to invest in stocks without paying capital gains or dividend taxes. This means it can be a much more efficient way to generate a second income than investing outside the wrapper, or investing in housing, or getting a second job.

Imagine I put £20,000 — the maximum input for a year — into an ISA right now. If the stocks I invest in can make about 6% returns, that would give me around £1,200 each year. But looking at this, it’s obvious that I have two choices: I could either wait longer while keeping my investment going, or adjust my expectations.

But let’s assume I’m sticking with my objective of targeting £12,805 a year in a second income. I’ve got to accept it’s either going to take more time, more money, or both.

Please note that tax treatment depends on the individual circ*mstances 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.

The project

I can’t just invest £200,000 in a Stocks and Shares ISA today, as that’s far above the maximum annual allowance. Time, therefore, is a critical component.

Of course, there are many different ways I could make it work. One way I can do this is by using a compound returns strategy. This is the process of reinvesting my returns, allowing me to earn interest on my interest as well as my contributions.

So let’s delve into this scenario in more detail.

Imagine I begin with an initial sum of £20,000 as my investment base. Alongside this, I commit to injecting an additional £300 into the investment every month. With a robust and attainable 10% annual return on my investment, I can project forward to the culmination of 15 years.

Of course, 10% is a strong yield, and if I choose my investments poorly, I could easily lose money.

After this period of consistent investment and strong returns, the calculated value of my investment portfolio would amount to an impressive £213,419.49. This outcome highlights the potential of compounding growth over time, underscoring the significance of disciplined and regular investing practices.

It’s a clear demonstration of the power that incremental monthly contributions, coupled with a favourable return rate, can have on the overall growth of an investment.

Taking passive income

With £213,419.49, I could generate £12,805 a year in passive income if I invested in stocks yielding 6% annually. This may involve a different investing strategy to the previous 15 years, involving investing in stocks which return more in dividends than share price gains, such as Legal & General.

However, it’s crucial to maintain a realistic perspective. While dividends do offer a source of passive income, they aren’t without risks. It’s important to acknowledge that the reliability of dividends isn’t guaranteed.

Furthermore, it’s prudent to recognise the evolving nature of the investment landscape over a 15-year horizon. As of today, there are around 60 stocks listed within the FTSE 350 index that boast yields exceeding 6%.

The accessibility of stocks with substantial 6% yields might prove more challenging in the future than it is today. Factors such as changing market dynamics, shifts in industry trends, and new company policies could all influence the availability of high-yield stocks.