Could a £20,000 ISA end up generating £20,000 of passive income each year?

At this time of year, many investors’ minds are on how best to utilise an ISA given the upcoming contribution deadline. While there is no deadline for actually investing the money already inside a Stocks and Shares ISA, I always think it is worth having a strategy for that too. Some people like to use it for buying growth shares. Like many investors, though, I see my ISA as a way to try and earn passive income thanks to stuffing it with dividend shares.

That can be both simple and lucrative. Rather than having to do the hard work myself, I can simply buy small stakes in large, proven businesses that use their spare cash flow to help fund dividends.

Could someone put in some money now and aim to earn back the equivalent amount every year at some stage down the line (while also hopefully benefitting from capital gains)?

Yes, they could – here’s how.

Understanding the role of dividend yield

A key concept in calculating how much an ISA may generate in cash is dividend yield. That is the amount a share pays annually, expressed as a percentage of its purchase cost.

At the moment, for example, the FTSE 100 yields 3.1%. So someone investing £100 would hopefully earn £3.10 in dividends annually.

I say “hopefully” because dividends are never guaranteed to remain at their current level. They can go down – but they can also increase.

The illustration I use here presumes the ISA compounds at an average annual rate – that could be from dividends but also capital gains, though any capital losses would eat into the return.

My presumption is a compound annual growth rate of 7%. After 40 years, the ISA should be big enough that a 7% dividend yield would produce over £20k annually of passive income.

I know – that is a long time to wait. A shorter timeframe could work too, but with a correspondingly lower passive income goal.

Lining up your ducks

Something else that can eat into the compound annual growth rate is dealing fees, commissions, and other ISA charges. So it makes sense to pay close attention when selecting a Stocks and Shares ISA.

My example above presumed a 7% yield, but that is over double the FTSE 100 average I mentioned. Still, in today’s market, I think it is realistic while sticking to a diversified portfolio of high-quality shares.

For example, one share I think investors should consider is FTSE 100 asset manager M&G (LSE: MNG).

The firm aims to grow its dividend per share annually. It has been doing so, as published in its annual results this month. The share currently yields 7.3%.

M&G’s share price has risen 40% over the past five years. That actually lags the 51% growth in the FTSE 100 over that period.

However, the fact that the share price is up by two-fifths yet the yield is still over 7% demonstrates how regular dividend growth can help an investor build passive income streams.

Can it last?

One risk I see is turbulent financial markets hurting investor confidence, leading some to pull money from their M&G policies. That could hurt profits.

But with its customer base in the millions, proven business model, and strong brand, I see M&G as a company well-positioned for the long run.

The post Could a £20,000 ISA end up generating £20,000 of passive income each year? appeared first on The Motley Fool UK.

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• How much should a 40-year-old put in an ISA to earn a £2k monthly passive income at 65? 
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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended M&g 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.

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