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A Stocks and Shares ISA can give me a platform for buying into companies that hopefully grow in value over time. Along the way though, it can also potentially be a source of passive income in the form of dividends.
If I had £20K in an ISA and wanted to target a 7% yield – equivalent to £1,400 each year, or almost £27 per week on average – here is how I would go about it.
Chasing yield alone is a fool’s errand
Perhaps surprisingly, I would not start by thinking about the 7% figure. Why?
Dividends are never guaranteed, no matter how much a company may have paid out before. So a share that yields 7% today can yield 0% tomorrow.
At the start of last year, Direct Line yielded around twice that much before axeing its dividend altogether. It has since come back, but at a much lower level.
So, to try and avoid falling into a value trap, I would look for companies that I think have a strong enough business and clean enough balance sheet to sustain a chunky shareholder payout over the long term.
Some characteristics of a good dividend share
As an example, I would point to Legal & General (LSE: LGEN).
It ticks a lot of the boxes I look for when it comes to buying dividend shares for my ISA. I do not own it, but would be happy to buy it if I had spare money to invest.
For a start, there is the target market. It is large, resilient and deep-pocketed. People spend a lot of money on retirement-linked financial services, often over the course of decades. Then there are the competitive advantages enjoyed by the firm. It has a familiar brand, long experience and large customer base.
That has helped make it consistently profitable in recent years. It plans to raised its dividend by 5% this year and 2% annually in the years after that. So the current 8.7% dividend yield could be set to become even juicier.
Even Legal & General has cut the payout before though. The 2008 financial crisis led to that and I see a risk that any sudden market downturn could hurt profits badly and see another cut.
As a long-term investor, though, I think the future for the firm looks promising.
Constructing a high-quality blue-chip portfolio
Owning a share like Legal & General ought to earn me more than my target dividend yield.
So I could hopefully still hit my target even if some of the shares I bought yielded less than 7%.
Right now in the FTSE 100 there are plenty of blue-chip shares earning 7% or higher besides Legal & General. From HSBC to M&G and Phoenix to Imperial Brands, quite a few firms offer such high yields.
Sticking to the share selection principles outlined above, I believe I could choose the right ones for my ISA and realistically aim for £1,400 in annual dividends.
