How much do I need to invest in my ISA for a second income of £20,000 a year?

Earning a second income from the stock market is a key objective for many investors, including me. With the ability to earn tax-free capital gains and dividends from a Stocks and Shares ISA, I think it’s possible to achieve this ambition by pursuing a long-term investing strategy.

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But how much would I need to invest to earn £20,000 in annual dividend income? And how long would it take to build a big enough portfolio? Let’s crunch the numbers.

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Buying dividend stocks

With passive income as a priority, I’m looking for dividend shares.

The average dividend yield for FTSE 100 stocks is currently 3.8%. However, some sectors are renowned for high-yield dividend stocks. These include tobacco, banking and housebuilding, among others.

Examples of FTSE 100 shares that feature in my portfolio are:

  • British American Tobacco — 9% yield
  • Lloyds Bank — 5.4% yield
  • Taylor Wimpey — 8.2% yield

With a £20k annual passive income goal, there are two key numbers for my modelling assumptions to ascertain how much I need to invest and how long the journey will take.

Dividend yield

First, there’s my target dividend yield. Essentially, this is the average yield across my stocks. Variations in the yield can produce very different numbers in terms of my required portfolio value.

To illustrate this, here’s the amount I’d need to invest to earn a £20k second income from a range of yields.

Compound returns

Second, I need to focus on my portfolio’s compound annual growth rate (CAGR). Essentially, this figure is the percentage increase in the value of my shareholdings from ISA contributions, share price appreciation and dividends reinvested.

For instance, if I aimed for a 5% average yield, I’d need a £400k portfolio. Let’s assume I saved and invested £10 a day. Here’s how long I’d need to hit my target at different rates of return.

So it’s clear the amount I’d need to invest for a £20k second income varies enormously depending on my average yield and my portfolio’s CAGR over time.

For example, if I invested £10 a day, stuck with a 5% target yield and my portfolio’s CAGR was 7%, I could invest £112,847 to hit my target £400k value in under 31 years.

Conversely, at a 3% CAGR, I’d need to invest £177,331 over a whopping 48.5 years to reach my goal! That’s an extra £64,484 and 17 years, eight months.

Managing risks

Dividend investing isn’t risk-free. Underwhelming returns resulting from bear markets or poor stock picks could mean my investing journey would take an incredibly long time. Or even require larger regular ISA contributions, as the above numbers demonstrate.

In addition, if companies cut or suspended their dividends, my required portfolio value would increase, as my average yield would drop.

However, via diversification and reliable dividend stock picks, it’s possible to unleash the enormous potential of compound returns. Which means I could generate a £20k second income in a reasonable timeframe for as little as a tenner a day.

The post How much do I need to invest in my ISA for a second income of £20,000 a year? appeared first on The Motley Fool UK.

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Charlie Carman has positions in British American Tobacco P.l.c., Lloyds Banking Group Plc, and Taylor Wimpey Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. and Lloyds Banking Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.