Individual savings accounts (ISAs) tend to attract people whose life goals eventually require cash. And goodness knows our cash savings could do with a jumpstart.
It's normally why we initially opt for cash savings accounts or cash ISAs - any sort of interest or savings income is a helping hand towards those life moments.
Stocks and shares ISAs go one further. They're there for those who've decided the prospect of investment return from the stock market, and the risks involved, are worth exploring because the alternative savings rates on cash accounts and cash ISAs on offer aren't attractive to them.
And the conversation tends to go down the route of investing for capital growth through an investment portfolio over the medium-to-long term (often up to retirement) because there's a house deposit or wedding to be paid for. Maybe not now but certainly before their pension savings become available.
In this sense, most of us see ISAs as a means to help us generate investment growth for one or two big expenditures but what if we chose to use a stocks and shares ISA for income over growth?
Why should I use my ISA for income?
We normally associate taking an income from our investment funds with retirement, and tapping into that pension pot.
While those long-term investments 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 withdraw your pension income 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 a tax-efficient 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 2023/24 tax year (from April to April).
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. Also, bear in mind that in most stocks and shares ISAs, once you put money in that portion of your personal allowance is used up. So, if you put in £10,000 and take it back out, you still only have £10,000 of your ISA allowance left.
ISA tax benefits
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.
US shares, UK stocks, ETFs, corporate bonds, government bonds - you name it, you can put it in your stocks and shares ISA.
And the reason you'll also hear that label one-upped to ‘tax wrapper' is because the account itself comes with some tax advantages. When you put your investments in an ISA, you don't have to pay capital gains tax or UK dividend income tax on any investment growth your assets achieve.
Tax treatment & tax rules outside of an ISA
If you invest outside an ISA, you have to contend with limitations on how much investment gain you can make before you have to pay capital gains tax.
ISAs & capital gains tax
For the 2023/24 tax year you have a capital gains tax allowance of £6,000. That means if you sell assets at a cumulative gain higher than your personal allowance you will have to pay tax on the part above the £6,000.
The rate of tax you'll pay depends on your level of income and which income tax band that falls into.
Basic-rate taxpayers pay 10% capital gains tax, while higher-rate taxpayers and additional rate taxpayers pay 20% in CGT.
There is a quirk if you're a basic-rate taxpayer though. If you add your investment gain to your income and it pushes you from the basic rate band into the higher-rate band, you're essentially considered a higher-rate taxpayer for capital gains tax purposes.
In this case, you'd pay 20% on the amount of your gain that falls into the higher income tax band.
So, while it might seem like a relatively small initial investment pot has little chance of tipping into CGT territory, mighty oaks from tiny acorns grow. It's better to plan for that possibility now than get there and wish you had used a stocks and shares ISA all along.
ISAs & UK dividend tax
In general, UK investors using non-ISA accounts can earn £1,000 in dividend income during the current tax year (6 April 2023 to 5 April 2024) without paying tax on it.
Once your dividend income goes above this so-called dividend allowance, how much tax you pay depends on the income tax band you fall into.
Basic rate taxpayers pay 8.75% tax on dividend income over the £2,000 allowance. Higher rate taxpayers pay 33.75% and additional rate taxpayers pay 39.35%.
Those rates reflect a rise of 1.25 percentage points to support the NHS, health and social care, from April 2022 for the 2022/23 tax year.
Again, putting that all into perspective, the £1,000 tax-free dividend allowance might sound unreachable for beginner ISA investors. But the point is that we're always hoping our investments grow.
That's one reason why long-term investors often hold income funds, which pay out dividends, in their ISAs. From an income perspective, it can make sense to make sure those dividends don't attract UK tax, no matter how much they, or the funds, grow.
While we're on the topic of using ISAs over the long term, remember 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 a regular income to spend during retirement, 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 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 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 still low, 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 this natural income stream 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 share price 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 and debt 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).
While it tends to be large caps that dominate the dividend picture, it's still possible to find income among UK smaller companies too. AIM shares aren't known for their commitment to dividends, because they're mostly laser-focused on growth over income.
But the latest AIM dividend monitor from Link shows AIM dividends rose by 7.4% in the first half of 2022 to £574m. Link Group expects 29% of AIM-traded shares to pay a dividend this year, so while it would be hard to find a small cap prioritising income over growth, it's not impossible to get income among the minnows.
Can you get property income in an ISA?
Property funds have been a popular choice among income investors over the past few years. If you are going to explore the sector, just make sure you know exactly what you're investing in. Whereas buy-to-let is a common route for non-stock market investors to try to generate a regular income, most property funds will concentrate on commercial property rather than residential property.
This means they'll often hold a portfolio of shops, offices and warehouses rather than houses or flats so there will be different external influences on the value of the underlying properties and the rental income they can demand.
There are even differences in the type of property fund you can invest in. Open-ended property funds (often called OEICs, or open-ended investment companies) are mutual funds full with one dealing point each day, normally around lunchtime. Real estate investment trusts (REITs) are different in that their shares trade on a stock exchange like the London Stock Exchange throughout the day.
There are a few more differences between a REIT and a property fund but when it comes to dividend income, a REIT must distribute 90% of its tax-exempt income profits to shareholders. If income has been derived from investment in another REIT then 100% must be distributed.
In times of market stress, open-ended property funds have been known to suspend dealing, while they try to sell enough of their portfolio to meet demand for redemptions. This potential lack of liquidity is one big reason investors have explored investing in commercial property through an exchange-traded instrument like a REIT.
None of this is a recommendation to dive into property funds, nor to avoid them. Just a warning to check what's under the bonnet and make sure it suits you before you decide on an investment.
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.
How to invest for income in your ISA
If you’ve considered the investment risks and weighed them up against the potential benefits of investing in dividend stocks, here’s a straightforward step-by-step guide explaining how to invest:
- Compare brokerage accounts to decide which one best suits your investing platform needs. Our investment fees calculator will help you understand the charges you could face.
- Open a stocks and shares investment account with your broker of choice. Make sure whatever platform you choose has the range of investments and investment products you need. You might want to factor in tax efficiencies and your time horizon, and consider whether a GIA, stocks and shares ISA or SIPP could help. Once you’ve decided, make your first deposit.
- Research the type of dividend stocks, dividend ETFs or investment trusts you want to invest in. Remember to have an eye on the current yield as well as any indication of future income stability. If there's a big difference between a dazzling headline yield and the actual annual income a trust or stock pays out, it could be a red flag. Unreliable sources of income will only cause worry and stress if you're relying on them, like those investing for retirement income.
- Make sure the mutual funds or individual shares fit in with your overall investment strategy, portfolio diversification, personal risk profile, and that the rest of your finances are in a healthy position.
- Select how much you would like to invest. Think about your portfolio and how you want to balance it between different positions, how much you can invest, and the frequency of investments to help figure out how big or small a holding you want.
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.