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One of the things I like about having shares in my ISA is the dividend income I can earn. That can be useful as a source of income. But I can reinvest those dividends (something known as compounding) to try to increase my long-term returns.
By doing that, I think I could try and use the £20K ISA to generate £2,000 a year in dividends over the next six years. Here is the way.
Above-average yields from high-quality companies
Assume I invest a £20K ISA at an average yield of 7% and reinvest. Ignoring the impact of share price changes (which can work for me, or against), a 7% compounded annual return will mean that after six years, my ISA yielding 7% should be big enough to make more than £2,000 in dividends. every year.
At that point, instead of continuing to accumulate dividends, I can start taking them out as sources of income.
7% is above the blue-chip average FTSE 100 company. The average FTSE 100 company currently yields 3.6%.
Anyway, that’s just it average. Some stocks offer more including what I see as very good businesses with potential to make money.
Finding stocks to buy
Diversification is an important risk management strategy. With a £20K ISA, I would aim to spread my money over five to 10 different shares.
To show the type of stocks I think investors should consider buying, I’ll zoom in twice.
One of them Legal & General (LSE: LGEN).
FTSE 100 companies have a history of increasing their annual dividends regularly. It aims for annual dividend growth of 2% over the next few years and is already yielding 8.9%.
However, no profit is guaranteed. Legal & General cut its payout in the last financial crisis and I see a similar risk the next time the markets crash if policyholders panic and the value of the company’s investment portfolio suddenly falls.
Still, I like the company’s focus on retirement-linked investment products. It’s a huge market and I expect it to stay that way. Due to its focus, industry expertise and historic umbrella brand, Legal & General looks well placed to capitalize on it.
Apart from the FTSE 100
As I said, I like to invest in great proven businesses. But I also consider small and medium-sized companies, including FTSE 250 index.
For example, one FTSE 250 share that I think income-focused investors should consider for their ISA is a household name. ITV (LSE: ITV).
Its current yield of 6.7% is slightly lower than what I mentioned above, but since that is an average it can be beaten by having the right mix of stocks that yield above and below 7%.
ITV management intends to maintain an annual dividend per share. But after falling 51% in five years, ITV’s share price suggests City is having its doubts.
One risk is the ever-expanding landscape of digital competitors pulling away from ITV’s traditional audience.
However, such competition would certainly help ITV’s division which leases studio space and provides production support.
Meanwhile, it is expanding its digital footprint and continues to leverage its legacy business.
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