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Stocks and Shares ISAs are a great tool for investors to target gains without exposing themselves to large tax bills from either capital gains or dividend tax. If someone has a large chunk of their current-year allowance left to use, here’s how a £12k sum could build passive income within the ISA wrapper.
Yields and compounding
To generate £1,000 annually straight away would require a portfolio yield of 8.35%. That’s possible, but I wouldn’t simply hunt for the highest-yielding FTSE shares. An unusually large yield can sometimes signal that investors expect the dividend to be cut. After all, if the dividend yield is high because the share price is falling, the dividend isn’t sustainable.
Instead, I’d spread the £12k across six to eight quality dividend stocks. I’d look particularly at sectors such as insurance, banking and investment trusts, where high yields can be found. This includes stocks such as Henderson Far East Income and Greencoat UK Wind, both with yields above 9%.
Because an ISA’s designed as a long-term investment pot, it’s not just the initial dividends that help it grow. It’s also the reinvestment. For example, £12k could turn into £13k after a year. That could then generate £1,085 the following year. By compounding and reinvesting dividends, I can boost the income paid over time.
I’d also consider adding fresh money to the ISA whenever possible. The annual allowance is £20k, so if I have more spare funds later in the year, I can put them towards building a larger income pot.
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.
Of course, dividends are never guaranteed. Companies can slash payouts during difficult periods, while share prices can fall significantly. So I can’t say for certain that the initial ISA investment will generate a four-figure income.
Strong momentum
When it comes to specific companies to consider, I like Ashmore Group (LSE:ASHM). The stock’s risen 27% over the past year, and comes with a dividend yield of 8%. For me, the biggest reason is investors are finally seeing evidence of a turnaround in fund flows.
The emerging markets specialist finished its latest financial year with assets under management (AUM) of £40bn, up 13%. Crucially, this wasn’t just rising markets doing the work. Ashmore attracted £2bn of net inflows, compared with hefty outflows in the previous year.
Investment performance has helped too. Some 77% of AUM was outperforming benchmarks over one year, providing a good advert to attract new client money.
The dividend’s a key attraction. Ashmore maintained its 16.9p annual payout, with dividend cover improving from 0.7 to 0.9 times. That’s still below the level I’d ideally like to see. However, the company has more than £600m of financial resources and converted 147% of operating profit into cash during the year. Therefore, I don’t see an imminent dividend cut as my base case.
Looking forward, I’m optimistic. Attractive emerging market valuations and stronger economic growth could encourage global investors to increase allocations. More inflows would lift AUM and, ultimately, management fees.
For sure, emerging markets can be volatile and the risk of a geopolitical shock could quickly reverse investor flows. Yet overall, I think the dividend’s sustainable enough for investors to consider this as part of the ISA income portfolio.
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Jon Smith does not hold any positions in the companies mentioned.
This story originally appeared on Motley Fool
