£500 or £5,000? Here’s an ISA income of £20k a year!

Some income ideas are easier than others – a a lot simple.

For example, my approach is to buy blue-chip shares in a proven business that will hopefully pay me regular dividends for years or decades to come without me lifting a finger.

I love that I benefit financially from great businesses that have proven they can make money.

But what if I only earn income where I have to pay most of it back to the taxpayer? To avoid that, I use a Stocks and Shares ISA.

Even with an ISA, however, fees and charges can eat into your income. So I think it makes sense for each investor to decide for themselves what ISA might best suit their individual circumstances.

Please note that tax treatment depends on the individual circumstances of each client and may change in the future. The content of this article is provided for informational purposes only. It is not intended to be, and does not constitute, any form of tax advice. Students are responsible for conducting their own due diligence and obtaining professional advice before making any investment decisions.

Determining the size of dividend income

There are three factors that come into play when determining how much income a person can expect to receive from the stocks they own.

The first is how much a person plants. In this example, that is £20k.

Second comes i dividend yield ratio achieved through the portfolio. That’s annual dividends as a percentage of what’s invested. So, for example, £500 a year equates to a 2.5% yield on £20k. That strikes me as very accessible and actually well below average yield FTSE 100 sharing right now.

Conversely, £5,000 would mean a 25% yield. Not only is it the highest of any FTSE 100 share offering, it’s so high I see it as a red flag. If a stock yields 25% (and some do from time to time), it often suggests that the market is expecting a dividend cut.

But there is a third factor at play – how long the investor holds the shares.

If the investor reinvests the gains at the beginning (a simple but powerful financial technique known as compounding), the long-term yield can be higher than the current one.

For example, compounding a £20k ISA at 7% per annum, after 19 years should be producing over £5,000 per annum in income.

Yes, that’s a long time to wait. But this is a serious long-term investment strategy, not some silly get-rich-quick scheme.

Finding stocks to buy

The good news is that I think today’s market offers opportunities to realistically target an average annual yield of 7% while sticking to blue-chip FTSE 100 shares.

Investing in many different stocks reduces the risk if one disappoints, for example, by reducing one’s profit.

One dividend yield that I think investors should consider is IM&G (LSE: MNG).

M&G’s yield stands at 10%. It aims to maintain or increase its profit every year. That’s not guaranteed to happen in practice, but the asset manager has raised its dividend per share every year in recent years.

With a large target market, millions of customers spread across multiple markets, a strong brand, and deep industry knowledge, I think M&G can continue to deliver.

Another risk is that customers withdraw more money than they put in. That happened in the core business in the first half of last year and it’s a risk I’m looking at.

Meanwhile, as an M&G shareholder myself, I am always attracted by the prospects of passive income.