Investing in an ISA’s probably one of the smartest ways to generate a second income, as all earnings will be completely tax-free for the rest of the time. Capital that’s put to work in an ISA is completely immune to capital gains and dividend taxes. And that’s more important than ever, given the annual allowance for such returns has been decimated in recent years.
Today, only up to £500 in dividends and £3,000 in capital gains can be earned tax-free. However, in an ISA, these limits don’t apply, allowing wealth to compound without HMRC dragging down performance.
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.
Hungry for dividends
One of the easiest ways to start earning a second income in the stock market is with dividend-paying stocks. These enterprises don’t usually provide much explosive growth. But the high-quality ones produce exorbitant volumes of free cash flow that pave the way to constantly growing reliable payouts.
Plus, this expansion of income can be further accelerated by reinvesting the dividends received over time. And best of all, the London Stock Exchange is filled with these types of stocks, meaning that investors are spoilt for choice.
Even now, after enjoying a rally in 2024, there are still over 65 British stocks in the FTSE 350 offering yields greater than 5%. And most have multi-year streaks of increasing payouts. So when looking to invest my £20,000 annual ISA limit to earn a second income, these are the first companies I’m going to take a closer look at.
Understanding yield
It can be tempting to chase after the highest yields in the stock market. And at first glance, this strategy seems to make a lot of sense. The higher the yield, the larger the dividend income. But in practice, a high payout level can actually be a giant warning sign to stay away. That’s because the share price also influences yield.
If a stock suddenly tanks, the yield will surge. A perfect recent example of this would be luxury fashion house Burberry (LSE:BRBY). The cyclical downturn in the luxury sector, paired with an ill-conceived shift in creative style, has led the stock to plummet more than 73% over the last 12 months. Subsequently, the firm’s historically modest yield now sits at 10.7% based on its most recent dividend payments.
Considering the FTSE 100 has historically generated an average total return of 8% a year, earning double-digits from dividends alone sounds extraordinary. But that’s dependent on Burberry maintaining its dividend policy. And since its cash flows are currently in jeopardy, this isn’t going to be the case.
In fact, management recently announced that dividends have been completely cancelled. As such, despite what’s displayed on many financial websites, Burberry’s yield is actually 0%.
That could change in the future as the brand steers itself back on track in a more economically favourable environment. Even more so, given that management’s recognised it has a problem and is taking action to try and turn things around.
But investors jumping in right now on the promise of a large yield without closely inspecting its sustainability are likely to be disappointed with the size of their second income.
This post was originally published on Motley Fool
