How to target £5,000 per year in passive income from shares

With the UK State Pension not enough to live on, targeting £5,000 in passive income to supplement can be a very good move.

One way to get that kind of annual income is to put a pot of £125,000 in a Cash ISA that pays 4% per annum. Then take the interest tax free. And some Cash ISAs actually offer returns around these days.

Does that sound like a winner? Well, it came back like this for a one-year stay, so I thought there was a better way.

Lower interest

One problem is that interest almost certainly won’t stay at 4% for long. It’s only possible now because Bank of England rates are so high, and to deal with inflation. When inflation falls, the base rate will fall. And, no doubt, will be Cash ISA rates.

For me, there are better alternatives. And that uses a Stocks and Shares ISA instead.

The tax protection of an ISA can be attractive. But saving tax is not a great benefit if the returns are poor to begin with. I’d rather pay tax on a superior return than get a lower tax return every day.

Please note that tax treatment depends on the individual circumstances of each client and may change in the future. The content in this article is provided for informational purposes only. It is not intended to be, nor does it become, any form of tax advice. Readers are responsible for conducting their own due diligence and seeking professional advice before making any investment decisions.

Stocks and Shares ISA

My preference is for Stocks and Shares ISAs, therefore, because of their history of solid returns. Over the past 10 years, we have seen an average annual Stocks and Shares ISA return of 9.6%.

There is no guarantee that it will be repeated. And some years, a Stocks and Shares ISA is likely to lose money. On average, returns fell by 13.3% in 2019-20.

How have stocks performed over a longer period of time? Over the past 20 years, the annual average FTSE 100 yield comes in at 6.9%. And I think most private investors would struggle to find anything that would generate better returns over the long term.

realistic goals

Targeting a 7% annual return from stocks seems realistic on that basis, at least with a long-term horizon. To earn £5,000 a year from a 7% return, we need a pot of around £71,500.

Building that money in the first place, with the same annual return, would take just over three years for someone who could invest an annual allowance of £20,000.

Of course, some of us have a lot to spare. But by investing an extra £100 per week, we can grow the pot we need in just about 10 years.

Best share?

Investing in Stocks and Shares ISAs really should be a long-term activity, I think. And investors should be happy to take the risk of short-term poor performance, even losses.

But I remain convinced that the most effective way to target long-term passive income is to buy shares in top UK companies. The more we can put aside each month, and the longer we can keep going, the more comfortable we will be in retirement.