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A stocks and shares ISA can be a good way to build wealth over the long term. This can come in the form of stock prices rising. But dividends can also be a source of income down the road.
In fact, owning an ISA full of dividend stocks can be a lucrative source of passive income.
If you had a £20,000 stocks and shares ISA and wanted to target £1,980 in dividends annually, this is how you would do it.
The importance of diversification
At first glance, the mathematics may seem simple. financial services company Phoenix It offers a dividend yield of 10.2%, for example. Therefore, putting my £20,000 ISA into Phoenix should net me over £2,000 in dividends a year.
The problem with that approach is that it concentrates my risk. Just because Phoenix has increased its dividend in recent years doesn't mean it will maintain it in the future. Vodafone It had an even higher dividend yield than Phoenix until recently, but a planned reduction means the expected yield is much lower than before. No dividend is ever guaranteed.
Therefore, with £20,000, I would invest my stocks and shares ISA in between five and ten different companies.
Find stocks to buy
Let's imagine, however, that I aim to obtain a dividend yield of 7%. On average, owning stocks like Phoenix would mean I could also invest in stocks yielding less than 7% and still reach my goal.
An example of a stock I would love to own is Legal and general (LSE: LGEN).
The company will benefit from the long-term resilient demand in the financial services industry. The type of pension-related products it specializes in can involve large sums and last for decades. That opens the opportunity for financial success for firms like Legal & General.
I specifically like its prospects because it has a strong brand, a large existing customer base and deep city experience that helps it both sell policies and manage the assets behind them.
I said earlier that dividends are never guaranteed and Legal & General is no exception. It has cut its payments in the past and could do so again if, for example, weak stock markets hurt the performance of its assets.
Still, with its 8.1% yield, I would be happy to buy this company for my stocks and Shares ISA if I had extra money to invest.
Complicating my dividends
Earning an average 7% return on my ISA would earn me £1,400 a year in dividends. It would be a welcome passive income, but it's a long way from my goal.
However, compounding dividends over five years would put me in a position to earn my passive income target of £1,964 annually from my stocks and Shares ISA. Hit the target!
