Here’s how a £20k ISA could generate £7,875 in monthly passive income

Investing in a Stocks and Shares ISA is a great way to target passive income. Once you’ve chosen which dividend stocks to buy, you can hopefully sit back and watch the money roll in. What’s more, any income drawn will be completely free of tax for life.

Fancy making a substantial second income with a Stocks and Shares ISA? Here’s one strategy to consider.

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.

Investing early on

With the new tax year under way, every adult in the UK has a fresh Â£20,000 ISA allowance to exploit. Not everyone has this much cash to hand and drip-feeding money into an ISA can yield brilliant returns. However, those who can start buying shares straight away can grow their wealth even faster.

Stock markets tend to rise over time, so getting money invested earlier increases exposure to long-term growth. Data from Vanguard backs this up — over a typical 12-month period, investing a large upfront sum has historically beaten drip-feeding cash about 68% of the time. Over three years, the odds improve to 74%.

Not only does lump sum investing win more often. It also tends to deliver higher returns over time, as gains start generating their own returns sooner. Over 12 months, this strategy typically earns around 2.3% more than spreading investments over the year. Over three years, this edge rises to 4.2%.

Let’s see how that looks in monetary terms.

A Â£297k boost

Say someone invests Â£20,000 at the start of each tax year over 20 years. While positive returns are never guaranteed, let’s also assume they secure an annual average return of 9%. At the end of this period, they’d have an ISA worth Â£1,350,000.

If they drip-fed that Â£20k over the course of each tax year, investing an equal amount each month, their eventual windfall would be Â£1,053,500. That’s a brilliant amount, but still almost Â£297,000 worse off.

What sort of investments could someone consider for a lump sum in to target a Â£1,350,000 ISA? Diversification is critical, and an exchange-traded fund (ETF) like the iShares FTSE 250 ETF (LSE:MIDD) can deliver this cheaply and easily.

It spreads investors’ cash over the whole of the FTSE 250 index. So it provides exposure to a wide range of industries and different parts of the globe. The advantage? It spreads risk and provides exposure to many growth and dividend opportunities.

On the downside, a focus on UK shares leaves the fund vulnerable if the broader London market underperforms. But this hasn’t stopped it delivering excellent returns over the last decade. Since early 2016, this iShares product has delivered an average yearly return of 8.7%.

A Â£1,350,000 ISA portfolio could deliver a Â£94,500 annual income if invested in 7%-yielding dividend shares. This works out at Â£7,875 per month.

And do remember that while lump sum investing can deliver outsized returns, even drip-feeding money into an ISA can help investors secure a comfortable retirement.

The post Here’s how a Â£20k ISA could generate Â£7,875 in monthly passive income appeared first on The Motley Fool UK.

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Royston Wild has no position in any of the shares mentioned. 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.