Investing in a spread of FTSE 100 and FTSE 250 shares is a superb way to build a second income stream. Especially if you buy them inside a Stocks and Shares ISA. That way, dividends and capital gains roll up free of dividend tax and capital gains tax, and withdrawals are tax-free too.
Other sources of retirement earnings are taxable, such as pension withdrawals. So generating a passive income from an ISA on top of that can help manage your overall bill, keeping you in a lower tax threshold.
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.
Crunching the figures
Let’s be ambitious here, and say an investor wants to generate a hefty £27,777 a year, purely from their Stocks and Shares ISA. That’s £2,314.75 a month, which would make a pretty handy extra income. Using the traditional 4% ‘safe withdrawal rule’, they’d need a mighty £694,425 to generate that level of income.
That sounds like a huge amount, but you don’t have to build the whole pot overnight. Compound growth can do much of the hard work, if you start early and give it enough time to work its magic. Remember to reinvest every dividend you receive along the way.
For example, someone putting £466 a month into a diversified portfolio of FTSE 350 shares, who got an average 8% annual return, could build a pot of roughly £694,000 over 30 years.
There are no guarantees you’ll get 8% a year, of course. Equities can be volatile, particularly over shorter periods, but history shows that over the longer run, they’re hard to beat.
A bank worth watching
One FTSE 100 share that income investors might consider is Lloyds. FTSE 100 banks have finally put the financial crisis behind them, and lately they’ve been making hay. The Lloyds share price is up 140% in the last five years and still rattling along, climbing 30% over 12 months. It’s paid lots of dividends along the way, yielding more than 5% at times.
The trailing yield has dropped to 3.3% today, thanks to those rocketing shares, but management is doing it’s best to put that right. The board recently hiked the interim dividend by 30%, while further rewarding investors with another £1bn share buyback. Lloyds is making bags of money. First-half net income climbed 9% to £9.7bn, with statutory profit after tax jumping 23% to £3.1bn.
The risk is that the shares slow after their strong run. The price-to-earnings ratio has crept up to 15.5. That’s roughly in line with a FTSE 100 average, but it’s more than it was for a long time. Today’s higher interest rates can help banks by supporting their margins, but also increase bad debts and put pressure on borrowers. Lloyds is heavily exposed to the troubled UK economy and housing market, so things could get stickier. But I still think it’s worth considering today.
Start early, stay invested
Most of us don’t have £466 a month to hand, but even starting with £50 can put investors on the road to a better retirement. Ideally, aim to build a portfolio of at least a dozen shares, to spread risk. I can see plenty more exciting second income stocks out there.
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Harvey Jones owns shares in Lloyds.
