ISAs can be a powerful part of your toolkit if you are looking to generate an income from your investments. You can use these accounts on their own, or in tandem with a pension or other assets.
Here are four ways for income investors to get the most from an ISA.
1. Maximise your tax breaks
Whether you are new to investing or you have been doing it for years, it is important to think about where you hold assets and whether the taxman will take a slice of your pie.
One of the biggest advantages of an ISA is that dividend income is completely free from income tax, regardless of your tax band. The same applies to capital gains, which means you pay no tax when selling an investment held in an ISA that is worth more than when you bought it.
In contrast, investments held inside a dealing or general investment account will be subject to tax on income and capital gains once you have used up personal allowances.
You might think tax is a problem for another day, but it is worth planning now. You will thank yourself in the future if you decide to protect all your income and investment gains inside an ISA, and there is nothing to pay the taxman on the fruits of your labour.
It is even more important to think about ways to minimise tax on your investments because dividend tax rates are changing. The dividend tax rate will go up from 6 April 2026 from 8.75% to 10.75% for basic rate taxpayers, and from 33.75% to 35.75% for higher rate taxpayers. The additional rate will remain unchanged at 39.35%.
UK residents can pay in up to £20,000 across the full range of ISAs each year, although there is a £4,000 annual limit on money you pay into a Lifetime ISA. Those who have children can also pay £9,000 each year into a Junior ISA, which will be accessible by the child once they reach 18.
2. Establish if you want income, growth, or both
There is misconception that income investing is only for people in retirement and that growth investing is only for those still in work. It is not that simple as both groups of investors might benefit in separate ways from both investment styles.
Someone in retirement might lean on their investments to pay their bills. The income stream from their ISA and/or pension effectively replaces the workplace salary they received pre-retirement. But that does not mean investment growth is no longer important. A person might still want their investment pot to keep growing as well as generate an income, so they have enough money to last their retirement.
In this scenario, one option is to consider having a fund designed to achieve a blend of income and growth, alongside income-dominant investments. The manager of an income and growth fund will pull together a mix of generous dividend payers with faster growing companies that might only pay a modest dividend, or not one at all.
Younger people might not have given thought to income if their primary goal is to grow the overall value of their pot. However, income funds could still work as part of their overall strategy.
Income funds typically look for companies with qualities such as strong cash flows, a large market position, and predictable earnings. An investor might see this as an uncomplicated way to add big, strong companies to their portfolio. Rather than pocket the cash from any dividends, reinvesting that money can help to turbocharge wealth over time due to the power of compounding.
Reinvesting will allow you to own more of an investment without putting your hand in your pocket to buy more shares or fund units. In doing so, you could qualify for even more dividends next time. Repeat this cycle over 10 or 20 years and you could be smiling all the way to a happy retirement.
3. Know the different options for income
There is more than one way to generate an income from investments. Shares and funds often pay regular dividends – think of them as cash rewards for the risk of having your money in the markets. Bonds pay fixed interest payments known as coupons, and this asset class is lower risk and may deliver lower returns than shares.
When deciding which income investments to make, you also need to think about how they might work for you.
If you invest for income, check:
How often are dividends paid?
Company shares typically pay out every six months, but larger ones can pay quarterly.
Income-focused funds might pay out quarterly, and there are certain ones that pay out monthly. Bonds typically pay once every six months.
If you type the name of a specific fund into AJ Bell’s website, you will find an information page for each one and there should be a box that says ‘Income frequency’ with details on how often you receive dividends.
Is the income paid out as cash or automatically reinvested?
Navigating the world of investments is not always straightforward. You might think you have picked a specific fund and then find out it does not act in the way you expected it to. We are not talking performance, but rather what it does with dividends.
Most funds come in two different versions – one that pays out dividends in cash and another that automatically reinvests dividends. The clue is in the fund’s name. It will have ‘Inc’ at the end of the name which means dividends come in cash; or it will have ‘Acc’ which automatically reinvests dividends. With Acc funds, the dividend increases the price of your fund units rather than number you hold.
Certain investors might choose to own the Acc version while they are building up their pot during their working life and then switch to the Inc version once in retirement.
If you do not need the cash paid out as dividends from shares, AJ Bell will automatically reinvest the money once you have requested this service for each investment. Simply go to your account and navigate to the dividend reinvestment service. This is available for most, but not all, shares.
4. Run regular health checks on dividends
Certain people just look for highest yield and pick that investment. You might benefit from doing more research on whether those dividends are sustainable. Check before you buy, and then periodically afterwards.
With shares, a high dividend yield can sometimes signal risk. For example, if the share price has fallen sharply, it suggests the market is worried about the company’s prospects or financial strength. If circumstances do not improve for the company, cutting or cancelling the dividend is a potential next step for them to save money. Just remember companies do not guarantee dividends each year.
Bonds trading well below their issue price might indicate the market is worried about the issuer. The key risks with bonds are default, namely the issuer failing to make regular interest payments and not being able to repay the capital when the bond matures.
If you invest in shares or bonds for income, try and find the answers to these questions:
- Is the dividend covered by earnings?
- Is the company generating strong free cash flow?
- Is the payout sustainable?
More experienced investors might be comfortable looking at a company’s financial results to work out the answers. Others might not know where to look, and you would not be alone in this situation.
In this case, you might want to consider actively managed income funds as the fund manager will do health checks on investments.
Certain types of passive income funds might also be of interest. For example, there are exchange-traded funds (ETFs) that have ‘quality dividends’, ‘quality income’ or ‘dividend leaders’ in their name, indicating they focus on companies that exhibit financial strength, and which are better placed to pay a growing stream of dividends.
The last thing you want is to invest in something and find the income stream is not sustainable. Dividends cuts happen from time to time, even among the biggest and best-known companies. That is why it is important to have a diversified portfolio, so you are not reliant on one particular investment.
Dan Coatsworth: Head of Markets
Dan Coatsworth is AJ Bell's Head of Markets. Dan has been with the company since December 2012 and has more than 18 years' experience in the industry, following the markets and all things investing. He...
