How I’d try to transform an empty £20k ISA into £55k of annual passive income

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Passive income is money for which I don’t need to expend much time or effort, or have a traditional job to earn it. That sounds pretty attractive to me.

Yet without a portfolio of buy-to-let properties, there aren’t that many ways of earning a second income without putting in the hours and the effort. There’s one key way though, and it’s my favourite: earning dividends from stocks.

Buy-to-let can be rewarding but it demands a lot more effort than buying shares. Plus rental income and house price growth is taxed, while dividend income and share price growth inside a Stocks and Shares ISA aren’t.

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.

Dividend stream

Today, stocks listed on the FTSE 100 pay average income of 3.8% a year. But I can generate more by targeting high-yield dividend shares like these five:

Legal & General Group — 8.14%
M&G — 9.89%
Phoenix Group Holdings — 10.61%
Taylor Wimpey — 6.51%
Burberry Group — 5.89%

I can’t afford to invest my full £20k allowance this year either but if I could, I’d diversify into a few other top UK income stocks.

HSBC Holdings (LSE: HSBA) is high on my shopping list. The Asia-focused bank pays an index-smashing income, with a trailing yield of 6.99%. It also looks good value, trading at 7.67 times earnings.

I’m surprised it’s so cheap, given that its share price is up 17.93% over the last year and 52.95% over three years. HSBC’s profits have been soaring too, up 78% to $30.3bn in 2023 as higher interest rates widened margins.

As well as the dividend, shareholders also benefited from a $7bn share buyback last year, and the board is pressing on with $2bn buyback in Q1.

No stock is without risk. When interest rates finally full, HSBC’s margins could narrow. It could also get squeezed in a US-China trade war. That’s why I’ll spread my money between different stocks rather than going all in on one.

FTSE 100 high yields

If I invested £5k across four different FTSE 100 shares with an average divided yield of 6%, I’d get income of £1,200 in year one. Investing is a long-term game, though. Let’s say I left the money in the market for 25 years, and it grew at the long-term FTSE 100 average of 8% a year, with all dividends reinvested. My £20k would be worth £136,969.

With that 6% yield, I’d generate an annual passive income of £8,218 a year. Which isn’t bad from a one-off £20k investment, made 25 years earlier.

Although I wouldn’t invest just for one year. I’d feed money into the market whenever I had some to spare. If I invested £20k in year one and £10k every year afterwards, I’d have £926,514 after 25 years. A 6% yield would deliver income of £55,590 a year. Now we’re talking.

Obviously, there are no guarantees. My shares could underperform. One or two companies could go bust. Alternatively, I could beat the FTSE 100 average. Either way, the principal holds. A passive income is a hugely attractive thing, and dividend stocks are a great way of achieving it. Without breaking a sweat (although patience is essential).