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One way I look to benefit from having a stocks and shares ISA is by earning passive income. Thanks to the dividends from shares I can get a second income even without having to work for it.
Doing that doesn't necessarily require tying up a lot of funds. If I had £9,000 left over now, I would happily put it into an ISA and use it to generate a second income. This is how.
1. Getting ready to invest
My first step would be to find the stocks and Shares ISA that best suits my needs and invest the money in it. There is no”“one size fits all” model for this, as everyone's financial circumstances and investment objectives are different.
Before I started putting money to work in the stock market, I took time to learn how the market works and establish an investment strategy. Just because a stock has paid large dividends in the past is no guarantee that it will pay them in the future (or, indeed, that it will pay them at all).
Therefore, I would spend time learning about where long-term dividend flows come from, from having a strong position in a resilient market to companies being able to use leftover cash for dividends rather than other things like paying out the debt.
2. Find stocks to buy
That £9,000 would be comfortable enough to allow me to diversify into several stocks. It would help reduce the impact on my ISA if one of the companies performed worse than I expected, which is always a risk.
Although my plan here is to generate a second income, I wouldn't start by simply looking for the highest-yielding stocks available. After all, dividends are never guaranteed to last. Sure, Vodafone still has a double-digit percentage return based on historical data. But the telecommunications company announced months ago that it plans to cut its pay per share in half.
Instead, I start by looking for what I see as a defensible business in an industry that benefits from strong customer demand and that I think is likely to last. I consider things like your balance sheet and likely future spending requirements when I judge what kind of payments I think you could afford in the future.
I have shares in Legal and general (LSE: LGEN), for example.
Financial services is a huge market and I see no reason to expect that to change anytime soon. With a strong brand, a large client base and long experience in its local market, I believe Legal & General will continue to perform well. It has a proven business model that has allowed it to make profits year after year in recent times.
It's also a major cash generator, supporting a dividend that already yields 9.3% and looks set to grow again this year. In practice, a sudden financial crisis is a risk if policyholders withdraw their funds, forcing Legal & General to marshal its resources carefully.
3. Use dividends to buy more shares
Even with a lower average return, say 7% (still well above the FTSE 100 average): £9,000 would enable me to earn a second income of just £630 a year.
But if I compound at 7% a year for 20 years, my £9,000 ISA today could be generating a second income of £5,654 a year.