How much passive income does a £20,000 ISA generate?

With a Stocks and Shares ISA, British investors can unlock an impressive tax-free passive income stream. In fact, with the right strategy, they can go on to earn Â£1,080 almost instantly, or potentially up to Â£4,416 each year in the long run.

So with the ISA deadline fast approaching, let’s breakdown how best to use the Â£20,000 annual contribution limit to maximise passive income.

Dividends tips and tricks

After a stellar surge in UK stocks last year, the popular FTSE 100 index has seen its dividend yield shrink to just 2.9%, well below its historical average of around 4%.

At 2.9%, a Â£20,000 Stocks and Shares ISA generates a passive income of just Â£580. That’s better than nothing, but many safer savings accounts offer better returns than this today.

However, instead of relying on index funds, investors can take control of their portfolio and concentrate their capital exclusively in the best and brightest dividend-paying FTSE 100 stocks. And this is where things get interesting.

By investing in the top 20 highest-yielding stocks in the UK’s flagship index, a portfolio would generate a 5.4% yield right now. In terms of money, that works out to be roughly Â£1,080 overnight â almost double what index investors can earn.

Yet, investors can potentially do even betterâ¦

Maximising long-term income

Generating a 5.4% yield with a diversified 20-stock portfolio sounds great on paper. But this strategy may end up backfiring. Why? Because higher-yielding stocks also come with more risk. And it’s not uncommon for shareholder payouts to end up on the chopping block, leaving investors pretty disappointed.

So what’s the answer? Free cash flow.

Companies that can consistently generate excess cash from their operations often end up being the businesses that are able to continuously increase their payouts over time. And after a few years, a small initial yield can grow into something truly impressive.

Take Games Workshop (LSE:GAW) as a prime example. In March 2018, the FTSE stock paid out a dull 3.4% in dividends. But through prudent leadership, management successfully capitalised on its Warhammer brands, growing the niche tabletop game into a multi-channel, wide-reaching hobby ecosystem.

The result? Exceptional pricing power combined with ever increasing sales volumes, opening the door to enormous free cash flow generation that has seen dividends grow by 550%.

As such, investors from 2018 have gone from earning a 3.4% yield to a 22.1% payout â enough to generate Â£4,416 passive income from a Â£20,000 initial investment!

Still worth considering?

Warhammer’s now more popular than ever, and the company’s expanding its audience reach through digital channels by licensing its IP.

This includes the highly anticipated upcoming TV series currently in development with Amazon. And with other successful licensing projects, particularly in video games, driving new customers towards its core hobby, the firm continues to fire on all cylinders.

Of course, no investment is ever without risk. Warhammer miniatures are quite an expensive premium product. And such discretionary purchases can often end up on the chopping block during economic wobbles as consumer spending priorities change.

Nevertheless, management has demonstrated a knack for navigating tough market conditions. And that’s why, despite the risk, I think Games Workshop’s worth considering for passive income-seeking investors.

The post How much passive income does a Â£20,000 ISA generate? appeared first on The Motley Fool UK.

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Zaven Boyrazian has positions in Games Workshop Group Plc. The Motley Fool UK has recommended Games Workshop Group Plc. 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.