Individual savings accounts (ISAs) tend to attract people whose life goals require cash, and whose cash savings could do with a jumpstart.
Stocks and shares ISAs go one further. They’re there for those who’ve decided the stock market, and the risks involved, are worth exploring because the alternative savings rates on offer aren’t attractive.
And the conversation tends to go down the route of amassing gains over the medium-to-long term (often up to retirement) because there’s a house deposit or wedding to be paid for.
In this sense, most of us see ISAs as a means to help us generate growth for one or two big expenditures but there is another way we can plan to use them: income.
Why should I use my ISA for income?
We normally associate taking an income from our investments with retirement, and tapping into that pension pot.
While those long-term savings are clearly geared towards letting you do just that (currently you can’t access your pension until you’re 55) planning to take an income from your investments doesn’t have to be confined to your retirement savings.
Using an ISA has the benefit of not requiring you to pay tax when you take your money out of it - something you have to consider when you take money from your pension later in life.
Of course there are things like company contributions and tax relief you get with a pension so they’re definitely not to be overlooked.
But what if your plan is to wind down in work before the age of 55, or before the state pension kicks in around the age of 68?
You might have plans to go part-time or just take on the projects you want. Income from your ISA could help supplement your pay until you can access your pension savings.
Before we get into how that’s even possible, let’s remind ourselves of the big picture around ISAs.
What is an ISA?
An ISA is an account you can use to put money away and, with a stocks and shares ISA, invest it for your future.
You can currently contribute up to £20,000 during the 2021/22 tax year (from April to April) and you’ll get a new £20,000 allowance for 2021/22.
You can put money in and take it out when you need it but it’s important to remember that if you’re investing you should take a long-term view.
A key thing to understand from the get-go is that the ISA is just the outer shell for you to fill with your investments - it’s not an investment itself.
That’s why you’ll often hear it described as a ‘wrapper’ - you get to decide on the filling.
And the reason you’ll also hear that one-upped to ‘tax wrapper’ is because, when you put your investments in an ISA, you don’t have to pay tax on any growth your investments achieve.
You can also only open one stocks and shares ISA with one provider each year.
If you find another company whose fees are lower, or whose platform just suits you better, you can either transfer your current ISA to them, or wait until the new tax year to open a brand new ISA with them.
Growth before income, or alongside it?
If you are using your ISA to build up your savings so that you can turn on the taps and take out money regularly to supplement your retirement income, arguably the initial stages should be about growth.
You’ll want to have as much in there to start off with, to give yourself the chance of making it last.
But that brings in the important question of how long you do actually want to take that income for.
Your ability to save now, your overall needs, your time horizon from now until then and how much risk you want to take will all have a bearing on how you should set up your portfolio.
Learn more: How to pick you investments
What are the best assets for growth?
Equities, or company shares, tend to carry the highest risk in the asset class neighbourhood but with that comes the opportunity for high reward.
If you’re setting yourself up for the long term now, equities could provide the growth you need, and have enough time to iron out any kinks caused by market volatility.
Of course, your portfolio should always be open to growth from a range of sources so be sure to diversify your holdings by sector, geography and company size.
Once you start to get closer to the time when you actually want to access your money, taking some risk off the table can be a sensible option.
You don’t want to suddenly be exposed to massive fluctuations in value when you need the money.
One option is to sell everything to cash and take your money out regularly.
You’ve taken the risk away but the problem is that inflation is now eating away at the value of your money.
What’s more, there is little opportunity for that money to grow any further.
Low risk assets like bonds have traditionally come into the conversation here but with interest rates at record lows, both cash and bonds can offer limited appeal.
What a lot of income-hungry investors have found is that they’ve had to climb the risk ladder into equity income (shares that pay out dividends) if they are to get any decent income at all.
A diverse spread of income sources, including shares offering sustainable dividends, can be useful.
These shares carry the opportunity to rise too, so if you only choose to spend the natural income that comes in dividends, and leave the shares alone, there is more chance of your money growing in the background.
If you don’t need a set amount of money every month and are happy to accept that these natural income payments can vary this can be a really helpful strategy.
What are the best stocks for income?
It’s normal to gravitate toward the stocks with the biggest dividends on offer but that might not be the best way to start.
Consistency is key and often high dividends won’t actually end up being feasible for the company to pay out, or they just look high as a percentage because the company’s value has fallen.
Look for sustainable dividend payers with long track records of being able to pay out through thick and thin and who aim for reasonable increases to their dividend every year.
Remember, the payment amount depends on the earnings that company makes.
So we need to make sure those earnings are strong and consistent enough to keep your dividends flowing.
Look at a company’s dividend cover too. This gives an idea of how sustainable its dividends are likely to be.
You'll often see it expressed as holding ‘2x’ or ‘3x’ the level needed to meet the next dividend.
Looking at the levels of cash on the balance sheet can help sort the leaders from the basket cases too.
Quite often the top dividend stocks of the moment stop being so good after that.
In short, a company’s ability to pay a dividend matters more than the dividend itself.
Where to look for equity income
The long-term average dividend yield of the UK stock market sits at around 4%. If you find consistency around or above that level but not so far as to make you wonder how sustainable it is, you’re on the right track.
Examples in the UK might be some consumer staples, big pharma and even the likes of British American Tobacco (BAT).
You can also have a look at the so-called dividend aristocrats who prize maintaining their dividends over almost everything.
Thankfully, there are exchange-traded funds (ETFs) that keep tabs on these types of stocks for you.
Examples here include the SPDR S&P US Dividend Aristocrats ETF, which tracks the 60 highest-yielding US stocks with 25 consecutive years of growing dividends, and the SPDR S&P UK Dividend Aristocrats ETF, which follows the performance of the best UK dividend stocks.
And have a look at the investment trusts in the dividend hero brigade. These are portfolios with the fund managers at the helm, searching the globe for growth and income opportunities.
A key highlight of trusts is their ability to put 15% of their income to one side in a year, so they can bolster payments to investors when dividend income suddenly becomes hard to find.
Check more investment content:
Protect your investments from UK tax with tax-efficient investing accounts like a stocks and shares ISA or a SIPP account. Check out the ins and outs of both accounts before opening one. Take a look at what is a stocks and shares ISA and our SIPP guide. We summed up the key differences in our SIPP vs ISA guide.
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.
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