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Using a stocks and shares ISA to earn passive income in the form of dividends is something hordes of investors do. I am one of them.
With a £20k ISA I think an investor could aim for a passive income of £574 per month.
But it will take time: this is a long-term plan.
Building great income streams
Let me start with some math, by way of explanation.
Investing £20,000 with an average return of, say, 6% could generate £1,200 a year in passive income.
But an alternative approach would be to invest that amount and then reinvest dividends along the way.
This is known as capitalization.
At some point of their choosing, an investor could stop reinvesting the dividends and start taking them as passive income.
Following the example above, compounding £20,000 at 6% per year over a decade would mean the ISA would be worth around £35,817. At a 6% yield, that could generate £2,149 in dividends, or around £179 per month.
Rolling a snowball down a hill
But with longer time horizons, things get worse. even better.
Investor Warren Buffett compares compounding to a snowball going downhill. The longer the hill, the more snow you can collect.
So in my example above, after 20 years, the monthly passive income would be approximately £320 per month. After 30 years, it would be £574 on average each month.
Implement the basics
However, before doing any of that, the question arises of which stocks and shares ISA to use.
There are many options available and I think it makes sense for an investor to consider which one seems most suitable. No two investors are identical.
Looking for high quality stocks to buy
Although I think a 6% return can be achieved even if top line investments are maintained. FTSE 100 shares, is substantially higher than the average performance of the FTSE 100 at the moment.
An example of an above-average performing FTSE 100 share that I think passive investors looking for income should consider is: Legal and general (LSE: LGEN).
The insurer has a yield of 8.9%. It has increased its dividend per share annually over the past few years and plans to continue doing so, although in practice what happens to a company's payout always ultimately depends on its financial performance. Nothing is ever guaranteed to last.
Legal & General cut its dividend after the 2008 financial crisis and I see the risk that that could happen again if financial market turbulence leads many policyholders to redeem their policies sooner than expected.
But I also see a lot of things I like here.
The insurance market is huge and Legal & General's approach to retirement gives it a clear strategic direction. It has a proven business model, a powerful brand, a large customer base and has been consistently profitable over the past few years.
I myself own this passive income powerhouse in my portfolio for precisely those reasons.
