Here’s how I’m trying to build a second income using a Stocks and Shares ISA

We’d all like a nice second income to help keep us going as we get older, right? I believe the best chance I have is to invest in UK shares and hold them for the long term.

Protecting it inside an ISA adds a nice bonus in that all gains are tax free when we take money out. And the £20,000 annual limit is more than enough for me. But for investors in different situations, a mix of an ISA and SIPP might be beneficial.

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 shares

So, I’m using an ISA. Next, if I want to build up income, I should go for dividend shares, shouldn’t I? After all, my investment in City of London Investment Trust (LSE: CTY) looks set for a 4.9% dividend yield this year. And the annual payment has risen for 58 years in a row.

When I want to actually start taking my annual income, I expect I’ll have just about all my savings in income-based investment trusts like this. Until then, I’ll keep reinvesting my dividend cash in new shares each year. But that costs me money in broker charges and stamp duty every time. And trading costs can add up over the years of my long-term plan.

Growth shares

So what about buying growth stocks that don’t pay dividends instead?

Artifical intelligence (AI) chip maker Nvidia (NASDAQ:NVDA) is probably the one on most people’s lips at the moment. Shocks from Chinese AI competition and the threat of trade wars have knocked half a trillion dollars off its market capitalisation. But Nvidia is still up 1,875% in the past five years.

I tried including these two stocks on the same price chart above. But when I set it to show a percentage growth comparison, the spectacular Nvidia climb means we just see at a flat line for City of London.

Growth vs dividends

There’s another way to think about comparing these two. I’ve just done a quick calculation. And I work out that to equal the five-year growth of Nvidia from City of London dividends, it would take more than 60 years at 4.9% per year.

Putting £10,000, or half an ISA allowance, in City of London five years ago and reinvesting the dividends, would result in around £12,700 now. That, in turn, would result in income of about £620 per year.

The same money in Nvidia five years ago would have soared to £197,500 today. That money, transferred to City of London, could result in £9,600 in annual dividends. That’s how we could try to use a growth stock to build up to regular dividend income. But it clearly comes with a lot more risk.

Total return

As individual investors, we need to consider how many years we expect to be investing. How well do we understand different kinds of stocks? How comfortable are we with risk? There’s a host of personal factors. But ultimately, one thing determines the size of the pot we can build over a specific timescale. It’s our total return, however we get it.

The post Here’s how I’m trying to build a second income using a Stocks and Shares ISA appeared first on The Motley Fool UK.

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Alan Oscroft has positions in City Of London Investment Trust Plc. The Motley Fool UK has recommended Nvidia. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.