How to create passive income within an ISA in 3 easy steps

Passive income investing has never been more attractive and it’s easy to see why. With the cost of living much higher than just a few years ago, a regular passive stream of income would prove to be a godsend for many people today.

The good news is that the London Stock Exchange is groaning under the weight of high-yield dividend stocks. These are companies whose payouts offer chunky income relative to their share prices.

Here, I’m going to explain how a UK investor can target lots of passive income through three straightforward steps.

Invest in a Stocks and Shares ISA

The first move is to open a Stocks and Shares ISA. This account shield all returns from HMRC, which reduces the hassle of paying taxes and thereby helps amplify the power of compounding.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Granted, a Cash ISA has been offering decent levels of income in the past couple of years. However, with interest rates now lower and tipped to continue falling, a Stocks and Shares ISA is more attractive, in my opinion.

In one of these, investors can buy high-yield dividend stocks, exchange-traded-funds (ETFs), and income funds. And unlike cash, these all have the potential to drive price gains as well as income.

Of course, such returns are far from nailed on. But including dividends, the FTSE 100 has delivered a 13.8% annualised return over the past five years. By contrast, cash has struggled to keep up with inflation.

Buy high-quality dividend stocks

After opening an account and depositing money, the next step is to identify high-quality dividend stocks. This can be quite challenging (in a good way) due to all the choice available.

But I think Admiral (LSE:ADM) could be a good income stock to consider right now. It’s down 22% since August and, disappointingly, around 7% over five years.

One issue currently irking the market is a change in how Admiral funds its employee share schemes. Instead of issuing new shares, the car insurance giant will now buy them back from the market.

Because this uses up cash, analysts expect it will leave less capital available for special dividends. So, there’s a risk of lower payouts moving forward, as well as some competitive pressures across the industry.

However, even when factoring in this reduced dividend outlook, the forecast yield is still around 7%, according to my data provider. So investors could bag more than £1,000 in annual passive income from a £15,000 investment, assuming the forecast proves correct.

This makes Admiral one of the FTSE 100’s highest yielders. And due to its strong brand, 11m customers, and data-focused, capital-light business model, I reckon Admiral’s dividends will keep flowing for years to come.

I believe the stock is worth a closer look at today’s discounted price.

Diversify the ISA

Finally, everyone knows the phrase ‘don’t put all your eggs in one basket’. This folk wisdom also applies to investing, as it can be dangerous to go all-in on just one or two stocks. Such overconcentration can lead to permanent losses.

Therefore, the last step is to build a diversified selection of dividends shares (10 to 20 is a good mix, in my opinion). A well-stocked portfolio makes it far more likely that passive income will flow regularly into an ISA.