With a £20K Stocks and Shares ISA, I’d target £1,964 in annual dividends like this

Photo of a man going through financial problems

A Stocks and Shares ISA can be a good way to build long-term wealth. That may come in the form of share prices moving upwards. But dividends can also be a source of income along the way.

In fact, owning an ISA stuffed full of dividend shares can be a lucrative source of passive income.

If I had a £20K Stocks and Shares ISA and wanted to target £1,980 in dividends annually, here is how I would go about it.

The importance of diversification

At first glance, the maths may seem simple. Financial services company Phoenix offers a dividend yield of 10.2% for example. So putting my £20K ISA into Phoenix ought to earn me over £2,000 in dividends annually.

The problem with that approach is that it concentrates my risk. Just because Phoenix has been growing its dividend in recent years does not mean it will maintain it in future. Vodafone had a dividend yield even higher than Phoenix’s until recently but a planned reduction means the prospective yield is far lower than before. No dividend is ever guaranteed.

With £20K, I would therefore invest my Stocks and Shares ISA across five to 10 different companies.

Finding shares to buy

Imagine instead that I set my sights on earning a dividend yield of 7%. As an average, owning shares like Phoenix would mean I could also invest in shares yielding below 7% and still hit my target.

An example of a share I would be happy to own is Legal & General (LSE: LGEN).

The company is set to benefit from resilient long-term demand in the financial services industry. The sort of pension-related products in which it specialises can involve large sums and run for decades. That opens the opportunity for financial success for firms like Legal & General.

I specifically like its prospects because it has a strong brand, large existing client base and deep experience in the City that helps it both sell policies and manage the assets that underpin them.

I said above that dividends are never guaranteed and Legal & General is no exception. It has cut its payout in the past and could do so again if, for example, weak stock markets hurt its return on assets.

Still, with its 8.1% yield I would be happy to buy this company for my Stocks and Shares ISA if I had spare cash to invest.

Compounding my dividends

Earning an average 7% yield on my ISA would earn me £1,400 per year in dividends. That would be welcome passive income – but is far short of my target.

Compounding the dividends for five years would, however, put me in the position of earning my passive income goal of £1,964 annually from my Stocks and Shares ISA. Bang on target!

Pound coins for sale — 31 pence?

This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

More reading

C Ruane has positions in Vodafone Group Public. The Motley Fool UK has recommended Vodafone Group Public. 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.