Here’s how much passive income someone could earn maxing out their ISA allowance for 5 years

Can an ISA stuffed with dividend shares be a lucrative source of passive income?

You bet it can!

That is not guaranteed to happen, of course. It depends what shares the investor chooses and how they perform in future.

But with careful selection of a diversified range of ISA shares, I think an investor could potentially turn an ISA into a long-term passive income machine.

Getting the ball rolling

Let’s imagine that someone puts the standard annual ISA contribution allowance of £20k into a Stocks and Shares ISA for each of the coming five years (presuming that allowance remains unchanged).

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.

How much will they have after five years?

Having put in £100k, the obvious answer might seem to be £100k.

But say that they have invested the money in dividend shares and reinvested dividends along the way. Compounding at, say, 7%, the ISA should already be worth around £115k after five years.

While there could be money coming in (from dividends), there could also be money going out (for commissions, dealing fees, and charges).

So a savvy investor will spend time carefully choosing the best Stocks and Shares ISA for them.

Looking to the future

Then what?

One approach would be for the investor to keep on compounding their dividends, year after year or even decade after decade.

That can be highly lucrative over the long term.

But while I am a believer in long-term investing, I realise that some people want passive income sooner rather than later.

So, in this example, the investor could compound for five years, then start taking the money out as passive income.

Even if they do not contribute another penny to their ISA, that ought to generate an annual dividend income of roughly £8,051.

Choosing the right dividend shares

That also presumes a 7% yield, as earlier in my example.

But right now, the FTSE 100 index of leading shares yields 3.1%. So is my target too ambitious?

I do not think so. After all, that average yield includes 100 different companies, some of which do not even pay dividends. I think a 7% yield is realistic in today’s market, depending on one’s investment choices. Some shares yielding less than 7% could be balanced out by some higher yielders.

One share I think investors should consider for its passive income potential is FTSE 100 cigarette manufacturer British American Tobacco (LSE: BATS).

The 5.6%-yielding share has increased its dividend annually for decades. That reflects the strong cash generation characteristics of its business.

The market for cigarettes remains large, smokers can accept regular price increases, and British American’s premium brands like Lucky Strike give it pricing power.

Still, there are challenges. The number of cigarette smokers is likely to keep falling. British American’s cigarette sales volumes are falling significantly.

But it can use its pricing power to mitigate such volume falls. On top of that, the firm has developed a non-cigarette business that may help it sustain or even grow revenues over the years to come.

The post Here’s how much passive income someone could earn maxing out their ISA allowance for 5 years appeared first on The Motley Fool UK.

More reading

• Does the Warren Buffett approach still work as he prepares to retire?
• I’ve never owned British American Tobacco shares. What on earth was I thinking?
• 3 FTSE 100 stocks pumping out passive income for over 10 years
• How much do you need in an ISA to take £23,184 per year as a passive income?
• These 3 high-yield income stocks boast a stunning 10-year dividend track record!

C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended British American Tobacco P.l.c. 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.

See author's posts