How much passive income could a £20k ISA generate in a year?

The FTSE 100 currently has a dividend yield of 3.4% – enough to turn £20,000 in a Stocks and Shares ISA into an investment that can return £680 per year. In passive income terms, that’s not exciting.

Over time, however, the equation can look much more positive. That’s because stocks have two important things going for them when it comes to generating cash for investors.

Compounding

The first big advantage with stocks is the opportunity to reinvest dividends in order to compound returns over time. And this can be a powerful force for income investors.

Reinvesting dividends from a £20,000 investment at 3.4% per year results in £937 in year 10, £1,316 in year 20, and £1,848 in year 30. And some stocks might offer the chance to compound at higher rates.

Shares in British American Tobacco (LSE:BATS) currently have a 7.2% dividend yield. At that rate, a £20,000 investment returns £2,840 in year 10, £5,822 in year 20, and £11,935 in year 30.

That’s a serious return. But the opportunity to reinvest dividends isn’t the only – or even the biggest – reason for investors looking for passive income to consider stocks as potential investments.

Growth

Companies can also increase the amount they pay out in dividends per share. So as well as owning more shares over time, investors can get more income from each share they own.

Some businesses have stronger records than others in this regard. British American Tobacco, for example, has an impressive history of growing its dividend per share over decades.

During the last 10 years, those increases have averaged around 4.5% per year. And that can make a significant difference for investors.

A £20,000 investment with a starting yield of 7.2% that grows at 4.5% per year can return £2,139 in year 10, £3,323 in year 20, and £5,161 in year 30. And that’s without reinvesting cash along the way.

Combination

Reinvesting income at high rates of return into businesses that can increase their dividend can yield great results. But investors need to think about the long-term picture.

In the case of British American Tobacco, the company has an impressive record of dividend growth. There are, however, reasons to be wary about this going forward.

For some time, the firm has been offsetting declining cigarette volumes with higher prices. While that has been very effective in the short term, I don’t think it’s a strategy with a long shelf life.

Furthermore, the longer it carries on, the sharper the eventual decline is likely to be. The question is when this happens and how far new products like nicotine pouches can make up the shortfall.

ISA investing

With where the stock market is right now, I think bonds might be a good option for investors looking for income in the next couple of years. But over the long term, stocks are the asset I prefer.

There are two key elements that investors focusing on dividend stocks need to consider. The first is the yield and the second is the likely growth.

Finding the balance between these two is key. But those who are able to do this could find themselves with an ISA that provides significant passive income.

The post How much passive income could a £20k ISA generate in a year? appeared first on The Motley Fool UK.

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Stephen Wright 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.