Does it make sense to use an ISA for passive income – or focus on growth shares instead?
One way many people earn passive income is by stuffing their Stocks and Shares ISA full of dividend-paying investments.
By contrast, some investors use an ISA as a vehicle to try and benefit from perceived long-term growth opportunities.
Does one approach make more sense than the other?
Utilising the power of the tax-free wrapper
For many investors, the ISA is a tax-free wrapper.
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.
From a capital gains perspective, clearly that could be attractive.
What about income? Here, too, I think a Stocks and Shares ISA could potentially be an attractive vehicle for investing. Over time, any dividends could pile up inside the ISA and in turn be used to buy more shares.
That process is known as compounding. Compounding inside the ISA could be a tax-efficient way for some investors to spend more than the annual ISA contribution allowance buying dividend shares, within the rules.
Once someone takes the money out of the ISA as passive income, it is outside the ISA wrapper. Putting it back in will eat into their contribution allowance for the relevant tax year.
Taking a long-term view
Some dividend shares start paying shareholders almost immediately upon buying them (though some stop, sometimes unexpectedly).
Meanwhile, although some growth stocks like Nvidia gain lots of value in a short timeframe, others are only rewarding on a long-term basis.
The patient investor may need to sit for many years waiting for a company to realise its potential, before that is properly reflected in the share price (if it ever is).
I think an ISA, as a long-term investment vehicle, can be well-suited to taking the long view. That makes sense when it comes to owning growth shares.
But I think it also has value for an investor focussed on dividend shares, too. Compounding dividends inside the ISA, perhaps planning to grow larger passive income streams for the future, can help an investor avoid the temptation of spending dividends as soon as they are earned, instead of reinvesting them to try and set up larger income streams in future.
Growth, income â or both
This is not necessarily an âeither orâ choice, then.
Some shares offer attractive income prospects, but potentially share price growth too.
A couple of shares I have bought this year because I think they fit such a bill are B&M and Greggs (LSE: GRG). But I would say the rationale for my approach in those two cases is different.
For B&M, I hope the battered share price could potentially bounce back, offering me possible share price growth alongside the juicy dividend yield. The growth prospects for the business look modest to me, though: it operates in a very crowded market.
By contrast, Greggs has also seen its share price crash this year. But as well as potential price recovery, I think there is an ongoing growth opportunity for the high street baker. It has set out plans to expand its estate of shops in coming years.
It is also seeking to gain more business by using current assets more at current down times, such as dinner.
Greggs shocked investors with a profit warning over the summer and I see a risk that having the wrong product range could again hurt growth prospects.
But if it avoids that risk, I think the share may yet offer me both growth and income!
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C Ruane has positions in B&M European Value and Greggs Plc. The Motley Fool UK has recommended B&M European Value, Greggs Plc, and 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.
