Image source: Getty Images
Investing in UK and overseas shares is considered by some to be the best way to generate a passive income. If held in a tax-efficient Stocks and Shares ISA, the returns can can be especially significant.
Holding shares in a General Investment Account (GIA) leaves investors vulnerable to capital gains tax and dividend tax. These can be up to 24% and 39.35% respectively, depending on one’s tax bracket. Over time, this can stack up to a colossal amount of cash.
With an ISA, investors are completely shielded from both of these taxes.
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.
Setting an ISA target
I think £30,000 is an attractive retirment income to target per year. That works out at £2,500 a month.
But how large would a retiree’s portfolio need to be to generate that sort of figure? Let’s assume they wish to draw down 4% of their nest egg each year. At this level, there’s a good chance their ISA will never run out, depending on the rate of portfolio growth.
Nothing is guaranteed, and stocks can be volatile. But the long-term average return on global stocks sits at 8% to 10%. Based on this, I think investors using the 4% strategy can realistically expect their ISA to at least remain intact.
Using this approach, someone chasing that £2.5k additional monthly income would need a £750,000 retirement fund.
Patience pays
I won’t deny it. That seems like a lot of money at first glance. However, an investor doesn’t need to max out their £20,000 Stocks and Shares ISA each year to reach that magic sum.
Time is the best friend of the patient and prepared investor. Through the miracle of compounding, where all past returns generate further returns, investors can watch their wealth snowball over the years and accelerate the longer they stay invested.
Even someone with a £500 monthly investment could hit that £750,000 retirement target, based on an average annual return of 9% over 28 years.
ISA investors have thousands of shares, funds, and investment trusts to choose from to reach their goal. I think an exchange-traded fund (ETF) that tracks the performance of large US shares could be one such asset to consider.
High-power US shares
The iShares S&P 500 ETF (LSE:CSPX) has — through a combination of capital gains and dividends — delivered an average annual return of 14.7% since October 2015.
That’s far ahead of the 9% average I mentioned, helped by its heavy exposure to fast-growing tech shares. Think the likes of Nvidia, Microsoft, Apple, and Amazon. As the digital economy has boomed, so have these companies’ earnings, driving their share prices through the roof and that of the ETFs that hold them.
An S&P fund like this is an effective way to balance risk and the potential for explosive rewards. It invests in 500 companies whose footprints cover different sectors and countries, which reduces the impact of localised pressures on overall returns.
So while tech shares can fall in value during sector downturns, the hundreds of other shares the fund holds can limit any temporary underperformance.
