How to invest for income using an ISA

For many people, the ability to achieve a regular income from investments is important.

This may be particularly relevant for people who are retired and no longer have a monthly pay packet to rely on and are looking to achieve financial freedom, while other people require their investment to pay out regularly to cover a regular commitment such as school or university fees.

So, how can you use your investments to provide a regular income? The key is to ensure that you choose the right combination of investments, and set up your portfolio appropriately to get the most tax-effective payout possible.

You can only receive £5000 of income from dividends on investments without being taxed... dividends paid on investments in an ISA are unaffected

The most usual way to get an income from investments is to rely on shares, bonds or funds that make regular payouts. These payouts are often called dividends. If you are investing in a single bond the payout you receive is known as a coupon.

In recent years, it has become particularly important for investors seeking income to use tax-efficient vehicles such as Stocks and Shares ISAs to shield their investments. This is because the government has introduced a dividend tax, which means that you can only receive £5000 of income from dividends on investments without being taxed. This dividend tax allowance is dropping to £2000 in April 2018. 

Dividends paid on investments in an ISA are unaffected, however, so it makes sense to use your £20,000 a year ISA allowance to shelter any income from dividend-paying investments. 

One of the simplest ways to invest for income is to use a fund that is specifically designed for the purpose. Equity income funds invest in shares that pay a high regular dividend, while there are also funds that provide an income through other assets such as bonds, or a mixture of assets.

Most funds will allow you to choose between two different shares classes, one known as ‘Inc’ (short for income) and one known as ‘Acc’ (short for accumulation). If you choose the ‘Acc’ class, the dividends paid on the shares in your fund will be reinvested. If you want your investment to pay you a regular income then choose ‘Inc’.

Investment Trusts, which are a type of pooled investment fund that is listed on the stock market, can be a good choice for those seeking income as they can hold back some of their profits in the good years to use to increase dividends in later years. Some investment trusts have increased their dividends every year for 50 years. These include the City of London Investment Trust, which focuses on equity income, as well as the globally focused Bankers Trust.

When picking investments for income you should be looking for companies with sustainable dividend policies

You could also choose to build a portfolio within your ISA of individual shares that pay high dividends. Whichever you choose, a key figure to look at is the ‘yield’ on the fund or stock you are buying. This figure is the dividend divided by the price of the asset, expressed as a percentage. But it is important not to just choose the stock or fund with the highest yield, as payouts are not guaranteed.

It is also important to remember that the value of your investment is also likely to change, and can move down as well as up. So even if you buy a share with a five per cent yield, you could still lose money if the value of the share itself drops dramatically.

When picking investments for income you should be looking for companies with sustainable dividend policies, with plenty of profit to continue paying out to their shareholders.

Dividend payments can be sporadic, with some funds paying quarterly, or even every six months, so if you need a monthly income you will need to give this some thought. There are funds that pay out every month that deal with this eventuality, though this may restrict your choice of investments as there are still not that many on the market.

An alternative might be to have all of your income payments from your ISA paid into a separate bank account, which then sends a regular monthly income to a current account.

Whichever way you choose to gain your income, ensure that you review your portfolio regularly. Company dividend policies change, and sectors move in and out of favour, and it’s important to keep an eye on whether your investments continue to align with your goals and risk tolerance.