Using your ISA to generate an income

A key benefit for ISAs is that all income generated within them is free from tax and doesn’t need to be declared on a tax return. As such, they’re a neat way to build up an additional income stream. Even if you don’t need the income today, there are reasons why prioritising income could be a good way to approach investment.

Of course, you could just stick it in cash. Many cash ISAs are paying an interest of 4-5%, and there are many savers who will be pretty happy with that. However, we’d make one key observation: the rates on savings accounts are generally not fixed, so if interest rates drop later this year, you may find your returns drop too.

You can often achieve a similar income or even higher by investing in the stock market, while retaining the potential for your income and capital to grow over time. Research from Schroders shows how powerful this can be – from 1926 to 2022, cash delivered real returns (above inflation) of less than 1% per year*. By contrast, the stock market has delivered just under 9%*. Compounded over decades, this makes a vast difference to your long-term savings — £10,000 growing at 1% over 10 years gives you a miserable £11,050, growing at 9%, it would hit £24,500.

Happily, there is greater choice of income options today than at any point in the last 15 years. But where to start?

Please remember that the value of investments will fluctuate and returns may be less than the amount originally invested. Tax treatment depends on your individual circumstances and the ISA and tax rules can change. Chelsea does not offer advice and so you must manage your ISA yourself.

Fixed income options

If you’re just dipping a toe out of cash savings, then a bond fund may be the right choice. You can often generate a higher income, and some long-term capital growth, but with less volatility than investors would experience with the stock market. With bonds, the level of income is set at the start and will be paid out unless the organisation issuing the bond defaults or goes bust. In the case of developed market governments and blue chip companies, this is (thankfully) rare.

The income available from bonds has risen as interest rates have risen. Yields of 6-7% are not uncommon for funds investing in blue-chip corporate bonds and the risks are relatively low. We like the TwentyFour Corporate Bond, run by a team of fixed income specialists. It currently has a yield of just under 6%** and invests in a carefully-selected portfolio of investment grade bonds. The Liontrust Sustainable Future Monthly Income Bond is an option for investors who want their money managed in a responsible way, plus a regular income.

Equity income options

When investing in the stock market, prioritising companies that pay dividends can be a good idea whether you need the income or not. Income is an important component of the total return from the stock market, particularly in markets such as the UK, which tends to deliver more of its return to investors through dividends rather than capital growth

In its forty year history, the FTSE 100 has risen from 1,000 to 7,733, implying annualised growth of just 5.3%***. Add in reinvested dividends and a £1,000 investment would have grown to £22,550, equivalent to an 8% return***.

Across the world, paying a dividend to shareholders can be a mark of quality. A company needs to have sufficient cash to do it, so its business needs to be healthy. Equally, it can show that the management team recognises the importance of delivering for shareholders and it can be a mark of good governance. As such, making income a priority can be a lower risk way of investing in the stock market.

Equity income funds – funds that prioritise dividend paying companies – have another key advantage: they can grow the income they pay out over time. This is not guaranteed and will depend on the profitability of the company, but over time dividends have generally kept pace with inflation.

In 2023, for example, UK dividends grew 5.4% overall****. Many economists believe that inflation is likely to be structurally higher from here and therefore this income growth may become more important. It is the equivalent of building in an automatic pay rise – and no thorny negotiations with your boss needed.

In the UK, the CT UK Equity Income fund is a traditional, core equity income fund, looking to provide an income yield higher than the FTSE All-Share Index. Its portfolio comprises familiar names such as Unilever, HSBC and Marks & Spencer**.

For a global option, investors could consider the Guinness Global Equity Income fund. Manager Ian Mortimer looks to balance capital growth with income generation and has a strong focus on quality. This should create resilience through different economic cycles. Its top holdings include Novo Nordisk and Microsoft^.

And a bit of both…

For investors who can’t decide which option they’d prefer, a multi-asset fund may be the compromise choice. One option is the VT Chelsea Managed Monthly Income fund, which has a yield of 5.7%^^, notably higher than the FTSE All Share yield of 3.8%^^^. The fund has a target weighting of between 40% and 60% in equities, although it may also invest in other assets including bonds, property, gold and alternatives. It’s top holdings include Man GLG UK Income and M&G Global Dividend, with around a third of the portfolio in fixed income^^.

After a tough time for income investors during the era of low interest rates, there is now plenty of choice, both for those investors who are tentatively moving out of cash to those willing to take a bit more risk with a stock market investment. Being brave enough to move away from cash can be a good option for the long-term.

*Source: Schroders, 21 August 2023
**Source: fund factsheet, 29 February 2024
***Source: The Guardian, 2 January 2024
****Source: ComputerShare, UK Dividend Monitor, Q4 2023
^Source: fund factsheet, 31 January 2024
^^Source: fund factsheet, December 2023
^^^Source: London Stock Exchange, FTSE All-Share, at 28 March 2024

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.