How big must an ISA be to aim for a £25,000+ a year second income?
The 1st of April each year always triggers a Pavlovian-style response in me to check I have fully utilised my £20,000 ISA allowance for the new tax year. This involves depositing the money into an ISA before midnight on Sunday (5 April).
Given the gusto with which successive governments go about relieving me of my hard-earned cash, it seems a crime to me to not fully use this exemption on income and capital gains tax.
The additional advantage of ISAs is that, unlike pensions, they have no age restrictions on withdrawals. So money invested in it (up to the maximum yearly allowance) can be withdrawn anytime in any amount with no tax penalties.
But how much am I targeting over time from it?
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.
High dividend yields
I always focus on high-dividend-yielding shares in ISAs. This is because a well-chosen dividend stock can provide additional significant returns over and above any share price gains.
And these can effectively be turbocharged through dividend compounding.
For long-term investors, the standard investment cycle is commonly regarded as 30 years. This starts with first investments at around the age of 20 and ends in early retirement options at about 50.
The current average dividend yield of the FTSE 100 is 3.1%, although these payouts can go down or up over time. So £20,000 invested at this average rate would make £7,258 in dividends over 10 years and £30,629 after 30 years.
Better returns could be had from investing in the UK 10-year gilt, known as the ârisk-free rateâ. It currently stands at 4.9%, so £20,000 invested here and compounded would make £12,614 in interest after 10 years and £66,725 after 30 years.
7%+ a year
I use the risk-free rate as the benchmark for the annual dividend yield I want in any stock. Right now, this is 7%+ as it compensates me for taking the additional risk of investing in shares over no risk at all.
Given that, the first name on my ISA this year was Legal & General (LSE: LGEN) — and not for the first time.
Its current dividend yield of 8.9% is one of the highest in any FTSE index. But analysts forecast it will rise to 9% this year, 9.2% next year, and a whopping 9.5% by 2028. A risk to these rises is the intense competition in the insurance and investment sectors that may squeeze its margins. Another is a sustained surge in the cost of living that may cause customers to close accounts.
Nevertheless, on the forecast 9.5% yield, my £20,000 investment here would generate £28,543 in dividends after 10 years and £265,968 after 30 years. By then, the total value of my holding (including the initial £20,000 investment) would be £285,968. And this would be paying me a yearly income (from dividends) of £25,451!
My investment view
Legal & General is not the only high-yielding share I have in my ISAs. And diversification of stocks in an investorâs overall portfolio is crucial to maximising returns while minimising risks over the long-term.
Over the past year, I have added several high-growth stocks to my holdings and have my eye on more ultra-high-yielding shares too.
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Simon Watkins has positions in Legal & General Group Plc. The Motley Fool UK has no position in any of the shares mentioned. 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.
