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An ISA can be a good way to generate passive income. Thanks to the dividends paid by the companies in my stocks and Shares ISA, I can earn passive income.
I have scoured the market to try to find what I think are the best stocks and Shares ISA. After all, I don't want to earn passive income in the form of dividends only to end up using a large amount to pay fees in my ISA!
Set a goal
The amount of passive income I can earn from my ISA depends on two things: how much I invest and the average dividend yield I earn.
The average dividend yield is not fixed. After all, a company can cut or increase its dividend. So even if I buy a stock today that yields 9.2%, such as Legal and general (LSE: LGEN) — that doesn't mean it will continue to return 9.2%.
In fact, Legal & General intends to increase its dividend per share by 2% annually in the coming years. But it has also cut its dividend before, such as after the 2008 financial crisis.
At 9.2%, Legal & General's dividend yield is well above the FTSE 100 average of 3.6%. But I think by investing in a mixed portfolio of blue chip stocks like Legal & General, you could realistically aim for an average dividend yield of 7% right now without leaving the FTSE 100 when looking for stocks to buy.
At that level, earning £500 a month (£6,000 a year) would require almost £86,000 invested in my stocks and Shares ISA. Not only is it a lot, but it is well above my annual ISA contribution allowance.
Invest for the long term
Therefore, I take a multi-year view on creating passive income streams. As well as contributing to my ISA regularly over time, I also try to increase its value by compounding dividends.
Even with a lump sum of £20,000, if I compound it at 7% a year, after 21 years I should have the amount I need in my ISA for a 7% return which equates to over £500 a month in dividends.
If I keep adding to my ISA over time, I could speed up that process. That's what I'm doing.
Find stocks to buy
What attracts me to a stock like Legal & General for a plan of this type?
After all, its profits in the last two years have been lower than in the previous years, and the share price has dropped by a quarter in the last five years.
Weaker earnings do concern me, and one risk I see is that a weak economy will hurt investment returns, which could lead some policyholders to switch providers. That could hurt profits.
But Legal & General has a lot of what I look for when I'm looking for stocks to buy for my ISA.
It operates in an area where I expect to benefit from strong long-term customer demand. The company has competitive advantages, from its well-known brand to a deep-rooted customer base. I feel like I understand the business and that's why I can evaluate it.
Additionally, more importantly, it has demonstrated its ability to generate excess cash and its willingness to use some of that cash to fund dividends.
