Image source: Getty Images
With the annual contribution deadline for stocks and shares ISAs falling next week, I've been thinking about what I could do with an ISA that could make a real difference to my long-term financial position.
One idea would be to aim for a second income in the future using £20,000 invested now in dividend stocks.
By doing that, I think you could realistically aim for an average dividend income of £1,900 a month. That's £22,800 a year.
The fundamentals of the approach.
Investing £20,000 in shares now and expecting more than that in dividends each year may seem impossible.
But that's from a short-term perspective.
If I invest in the right stocks, time can be my friend. Over the long term (a period for which I believe an ISA may be suitable), I think you could realistically aim to turn a sum of £20,000 into a second income of £22,800 each year.
If I reinvest my dividends By buying more shares, I could hopefully build a larger ISA from my initial investment of £20,000.
That simple move, known as compounding, could help prepare me for significant dividend streams in the future.
To illustrate, imagine I could compound my ISA value at 9% per annum. After three decades it would be worth more than a quarter of a million pounds. At that point, a 9% annual return would be more than £1,900 each month.
Growth and income
A 9% annual return alone does not necessarily equal income. It could come from growth in the valuation of shares held in the ISA, for example.
So to reach my second average monthly income target of £1,900, I would eventually need an ISA that returned 9%, not just one that produced a compounded annual return of 9%.
But that will be in the future. For now, a 9% cap would be fine, whether it comes from share price growth, dividends, or both.
I might look for some dividend yield later, when it's time to receive my second income.
As I explained above, this is a long-term plan. If an initial £20,000 can be turned into a portfolio worth more than a quarter of a million pounds and generate dividend income each year greater than my current investment, I'd be happy to wait!
Find stocks to buy
How realistic is a 9% compounded annual return over a 30-year period? It is more difficult than it looks. But I do believe it is possible.
I would diversify my £20,000 into five to 10 different blue chip stocks. I would be looking to invest in companies like Legal and general (LSE: LGEN).
It currently has a dividend yield of 8%, although in the last five years the shares have fallen 7%. The reason I like the stock is that I think it has the makings of a solid long-term business and is currently selling at an attractive valuation.
Operating in a market that is likely to benefit from long-term resilient demand, Legal & General enjoys advantages including a large existing client base and a strong brand.
Wobbly financial markets could lead customers to withdraw funds, hurting company profits. However, as a long-term investor, it has all the hallmarks of the type of share I would happily own in my ISA.
