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Using an ISA to generate a second income is a simple but potentially financially liberating idea. After all, I could fill a stocks and Shares ISA with juicy dividend payers and then sit back and hopefully watch the money come in.
Turn an ISA into a gold mine
My first step would be to create a stocks and Shares ISA.
I would then prepare to make a regular weekly payment of £180. It's important not to get too obsessed with the number. Instead, I could invest monthly and contribute more or less depending on my financial circumstances. The point is simply to get into the habit of making regular contributions to my ISA.
Sticking with the £180 as an example, putting it into an ISA each week would give me £9,360 a year to invest.
How Compound Dividends Can Help Build Wealth Faster
But I could invest more money without even increasing my regular contributions.
As? Using the dividends I receive.
This is known as capitalization. While billionaire Warren Buffett is a highly successful investor, his company does not pay dividends. This is because you invest the money you earn into making more money.
I realize now that it may seem like I'm missing the point of generating a second income. Why put money into the ISA regularly and not take anything out?
Actually, I would delete it, but not yet.
Imagine I invest £180 per week at an average compound growth rate (thanks to dividends) of 7% each year. After a decade, I would already be generating £9,343 annually in dividends from my ISA. You could continue compounding or choose to start earning passive income at any time.
Finding Income stocks to Buy
That may not seem complicated. It doesn't have to be like this. In fact, simplicity is the goal of earning passive income.
But one thing that could affect my results for better or worse are the stocks I buy in hopes of reaching my 7% return goal (which is well above the average return of the FTSE 100 right now, although in the current market I still think it's a reasonable goal).
I would invest in different stocks, since even the best managed company can encounter unexpected difficulties.
Turning theory into practice… and into pounds!
An example of the type of stock I own in part for its passive income potential is Legal and general (LSE: LGEN).
With a return of 9.2% (yes, 9.2%), the FTSE 100 financial services company beats my target. Its policy is to increase the payment per share each year: currently by 5% and starting next year by 2% annually.
Something that's important to understand when buying income stocks is that no dividend is ever guaranteed, and that includes Legal & General. It cut its dividend during the last financial crisis. If another economic storm leads policyholders to withdraw funds, hurting the company's profits, I think the same thing could happen again.
But with a large potential market to address, a large customer base, a well-known brand, a proven business model and a track record of generating cash, it's the kind of dividend stake I like to have.
