Tax is an unavoidable cost but a necessary one to keep the country’s cogs turning. And with a Stocks and Shares ISA, UK residents can contribute to the country’s growth while simultaneously reducing their own tax outgoings.

This is achieved through investing in UK shares with an ISA, helping boost the local economy and rewarding you with a nice tax benefit.

An ISA account holder can invest up to £20,000 a year tax-free into a wide range of assets, including shares, ETFs, commodities and bonds. With smart portfolio allocation, the returns can substantially outweigh those of a standard savings account or Cash ISA.

And if you focus on dividend shares, as I do, you could achieve a lucrative passive income. So what kind of returns should an ISA holder expect from a one-off £7,000 investment?

Crunching the numbers

UK dividend shares are a varied bunch. On one side, you get your safe options such as consumer staples Unilever, healthcare stocks like GSK, or energy giants like BP. These tend to deliver stable returns but at a lower yield around 3%-4%.

Finance stocks often give a better return, with many banks offering a solid mix of growth and dividends. Meanwhile, insurers such as Legal & General typically have the highest yields (8%+) but come with more complex risk.

Aiming for a balanced mix is often cited as the most beneficial route to take. So consider the following portfolio example:

I find aiming for a 7% average yield is usually sustainable, which would return £490 on a £7,000 investment. Reinvest those dividends for 10 years and your pot could compound to nearly £20,000, paying £1,400 a year (assuming 3% capital growth).

Let’s look at how I chose these stocks, using Dunelm Group as an example.

A defensive high-yielder

As mentioned above, most defensive stocks tend to have lower yields. Dunelm’s one exception. At 6.5%, it’s almost double the FTSE 100 average and yet it still looks stable and sustainable.

The retailer benefits from consistent demand for furniture, kitchenware and home improvements, making it resilient through market cycles. That’s backed by a solid track record of dividend growth: besides a cut during Covid, shareholders have enjoyed uninterrupted growth since 2007.

Its huge network of both physical and online stores has helped revenue grow from £1.06bn in 2020 to £1.77bn today.

It’s worth noting however, this year’s special dividend is down from 35p to 25p. If the final dividend isn’t significantly increased, this year would be the first full-year reduction since the pandemic. 

Likely, the company expects slower growth in the next results, prompting a cautious approach. It’s a smart move but it does highlight the unavoidable risks posed by a weakening economy and reduced consumer spending.

The bottom line

All stocks face macroeconomic risks, and Dunelm’s no exception. But its high yield and long history of dividend growth makes it a good stock to consider for an income portfolio.

When targeting income, I always stick to three standard practices: diversification, sustainability assessment, and compounding through reinvestment. It requires patience and dedication but, in the long run, it usually pays off.

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Mark Hartley owns shares in Unilever, GSK, BP, Legal & General, Standard Life, National Grid, and British American Tobacco.