How I’d try to turn a £20k ISA into a second income of £8,117 a year

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I’ve already got a main job but I’d like to generate a second income and my preferred way of doing this is by investing in FTSE 100 shares.

Companies listed on London’s blue-chip index pay some of the most generous dividends in the world. Currently, the average yield is around 3.5%, but this is forecast to hit 4.2% over the next 12 months. By contrast, the US S&P 500 yields just 1.64%.

That gives only half the picture. I’m not buying a tracker, but individual FTSE 100 stocks. I do that to generate a higher rate of income as some companies offer much higher yields than others.

Planning for the future

Better still, many of them are trading at mind-blowingly cheap valuations. A quick review throws up five FTSE 100 stocks that I would buy today with yields of 7% a year or more, while trading at less than 10 times earnings. I have bought three of them in the last six months (and would love to top them up).

Legal and General Group yields 7.6% and trades at 6.6 times earnings. Rio Tinto yields 7.68% and trades at 7.8 times earnings. Fund manager M&G yields a staggering 9.69%. Its price/earnings ratio is negative, at -3.1, due to a sharp drop in earnings last year, but these are forecast to recover in the year ahead, keeping the dividend affordable. Fingers crossed!

I would also like to buy housebuilder Taylor Wimpey, which yields 7.74% and trades at 6.5 times earnings. I don’t buy tobacco companies, but I still admire the 7.45% yield from British American Tobacco, which trades at just 7.8 times earnings.

If I split a £20,000 ISA equally between these five stocks, investing £4,000 in each, I would get an average yield of 8.03% a year. That would give me income of £1,664 in year one. Which is great but well short of my £8,000+ target.

Growing nicely over time

The real benefits of buying income stocks only reveal themselves over the long run, as my back-of-a-fag-packet calculation shows. Let’s say I was retiring in 30 years, and I re-invested all my dividends for growth. That 8.03% yield would give me £202,937 by the end of that term.

I would aim to draw 4% of that as a second income at retirement. This percentage is known as the safe withdrawal rate, because it means the underlying capital should never be depleted. From £202,937, I would generate income of £8,117 a year. Not bad for an original stake of just £20,000. Plus I can pass on my portfolio to loved ones as an inheritance when I die.

My crude calculations are subject to many variables. The obvious risk is that some of the companies axe their dividend, or even go bust. Another is that inflation will erode the real value of that income over time. On the plus side, I haven’t allowed for any share price growth in my calculations, and there is a pretty good chance I will generate a lot of that over such a lengthy period.

With luck, I could end up with a portfolio worth much more than £200,000, and a higher second income than the one I’ve calculated here.

The post How I’d try to turn a £20k ISA into a second income of £8,117 a year appeared first on The Motley Fool UK.

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Harvey Jones has positions in M&G Plc, Persimmon Plc, and Rio Tinto Group. The Motley Fool UK has recommended British American Tobacco P.l.c. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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