Many UK investors see a Stocks and Shares ISA as the perfect home for a tax-free dividend portfolio. Dividends can provide regular income, while the ISA shelters dividend income and capital gains from tax.

For someone building a second income or planning for retirement, that sounds straightforward. But while dividends clearly play an important role, I wouldn’t automatically fill an entire ISA with them.

Chasing the highest average yield isn’t necessarily the best investment, and focusing too heavily on income can mean overlooking total returns (capital growth combined with dividends). Over decades, the difference can be substantial.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

The danger of chasing yield

A large yield isn’t always good. If a company’s share price falls while its dividend remains unchanged, the yield naturally increases. If profits are falling, cash flow is weak or debt is becoming harder to manage, the dividend could be cut.

So before diving in for dividends alone, I would examine:

• Whether earnings comfortably cover the dividend.
• Whether the business generates enough cash to fund the payout.
• Whether debt is rising while profits stagnate.
• Whether management has a record of maintaining or increasing dividends.

This doesn’t mean every high-yield share is dangerous – it just means yield should be the starting point, not the whole story. Growth matters too.

A company that reinvests profits may offer little income today but create greater value over time. Reinvested dividends can compound, but so can rising earnings and a growing share price.

Diploma shows another route

Diploma (LSE:DPLM) offers a useful example of why an ISA portfolio needn’t be built around high yields alone. The specialist technical products group reported revenue of £1,524.5m for the year ended 30 September 2025, up 12%.

Organic revenue growth was 11%, adjusted operating profit rose 20% to £342.7m, and free cash flow increased 25% to £247.2m.

But even while the dividend recently rose 5% to 62.3p, the yield isn’t even 1%. That’s low compared with many popular FTSE income shares. It’s the compounding growth that matters here. In Diploma’s latest annual report, adjusted earnings per share (EPS) grew at an 18% compound annual rate over the previous seven years.

That doesn’t guarantee future returns. As an acquisition-heavy company, Diploma faces the risk of a badly executed integration or overpaying for a business. That makes debt management a concern, particularly if supply shocks impact profitability.

The advantage here is stability and defensiveness. Diploma operates across varied sectors, including life sciences, seals and controls. These specialist products serve customers where reliability matters, while diversified operations and acquisitions have supported expansion.

A balanced ISA may win

A purely income-focused portfolio might produce more cash initially, particularly if it’s packed with high-yield banks, miners or energy shares. Yet it could suffer if commodity prices fall, profits weaken or dividends are cut.

A balanced portfolio containing dividend shares, global funds and growth companies may produce less income at first but offer stronger compounding potential.

Remember, a Stocks and Shares ISA is just a tax wrapper, not an investment strategy in itself. Income shares have a place, but focusing on them alone for the tax-free dividends could be detrimental. That’s why stable growth stocks like a Diploma are also worth considering in an ISA portfolio.

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Mark Hartley owns shares in Diploma.