What is a monthly income ISA?
A monthly income ISA is a Stocks and Shares ISA holding investments that pay monthly dividends or income payments.
As they are ISAs, the income and dividends are completely tax-free.
You don’t have to declare your income on your tax return or add it on to your existing earned income.
As a bonus, any investment growth your income paying investments make while you hold them is also free from capital gains tax.
What does a monthly income ISA invest in?
Monthly income ISAs come in two forms:
- Ready-made income portfolios
- Self Select or DIY income portfolios
If you pick your income portfolio yourself, there are various types of income paying investments to choose from.
However, a ready-made income portfolio will most likely invest in a combination of managed funds (OEICs and Unit Trusts), Investment Trusts and Bonds.
Ready-made income ISA portfolios
Ready-made income portfolios are categorised by risk level, and you pick the one that suits you best. Options can range from defensive or cautious, to balanced or adventurous, and each one will have different underlying investments.
More adventurous portfolios have higher risk investments within them that are more likely to fluctuate in value.
Cautious and defensive portfolios invest in more stable investments that are less likely to fluctuate dramatically in value but still pay an income, such as Bonds. They can still lose money, however, as all stock market investments can.
Ready-made portfolios are created and managed by professional fund managers, which means they don’t come cheap. You have the peace of mind that they are being invested well, but you will pay higher ongoing charges for the privilege.
Self Select Income ISA portfolios
Self Select Stocks and Shares ISAs require you to pick your investments yourself. Therefore, if you want an ISA that pays you a monthly income, you need to invest in holdings that do this.
The most popular income-producing investment types are:
- Investment Trusts
- Unit Trusts
Investment Trusts, OEICs and Unit Trusts are similar products and all fall under the umbrella of ‘managed funds’. The main differences are how they are structured legally, and how they are traded.
Managed funds pool their investor’s money together and invest in a portfolio of companies within a specific sector or region.
Income funds are a type of managed fund. They are funds that specifically invest in:
A) companies that produce regular and high dividends
B) debt securities and bonds issued by corporations or governments that generate high levels of interest
Shares pay dividends on a monthly, quarterly, biannual or annual basis, and the amounts usually vary depending on how much available cash the company has. A company with a large, reliable cash flow is more likely to pay regular, high dividends.
Bonds are corporate or government lending investments that return an annual target interest rate. They are classed as lower risk compared to some other stock investments, but they can still go down in value.
How to pick an income fund portfolio
If you’re selecting your own income funds, look at the yield they aim to produce. The yield represents the percentage of your investment's’ value that they aim to pay out in dividends.
For example, a fund with a yield of 5% will pay out £500 over a year on a £10,000 investment.
A fund’s ‘historic yield’ gives you an idea of what dividends it has paid in previous years. However, this doesn't guarantee it will reach the same figures in future yields and the amount will fluctuate.
Income funds invest in a range of companies and products that are likely to produce high dividends or generate interest.
Here are some easy ways to identify income funds:
- They’ll have ‘income’ referenced in the fund name, for example, ‘high income’ or ‘income focus’.
Note: this doesn’t include the unit type of either income or accumulation - more on this below.
- Look out for other dividend related keywords, such as ‘yield’ and ‘dividend’.
- For interest producing funds, look out for keywords like ‘debt’ and ‘bond’.
What’s the difference between Income and Accumulation funds?
All Unit Trusts and OEICs come both income and accumulation classes. The underlying holdings of the two fund classes will be exactly the same, and the only difference is what happens to the income they produce.
An income class fund pays dividends out to holders of the fund.
An accumulation class fund automatically reinvests all its dividends into the value of the fund. Income never leaves the investment and is just added on to the performance.
For example, if you compare the performance of accumulation and income units of the same fund, the accumulation fund will have higher growth, but the income fund will have produced an annual yield to the equivalent value.
This is where you need to be a bit careful when picking income-producing managed funds.
Every managed fund has an income class, even if they don’t invest in high income-producing investments.
All managed funds produce dividends regardless of whether they target high dividend shares, so make sure the income fund you’re looking at definitely focuses on income-producing investments.
When you’ve picked your income fund, make sure you get the income units as well if you want to be able to withdraw the income payments from your ISA into your bank account.
How to pick an income paying share portfolio
If you’re buying shares instead of funds, you just need to invest in companies that pay out regular, healthy dividends.
Look at shares that have previously paid out good dividends and read their shareholder information to see whether they intend to keep this up.
There is no limit to the amount of research you can do before investing in an individual company, so make sure to put a good amount of time into your decision.
Investing in a single company doesn't diversify your investment like funds do. Your risk is not spread across multiple companies which means your portfolio is vulnerable to volatility in a single company’s share price.
Don’t forget about growth
While it’s great to focus on the yield that your income ISA generates, don’t forget about protecting your investment growth.
If a company or fund pays 5% in dividends each year but also loses 5% of its share price, you’re not really getting anywhere.
Some funds look to generate a mixture of income and growth - these are often labelled with ‘income and growth’ in the fund name.
How do I withdraw regular income from my ISA?
Once you’ve got your income investments within your Stocks and Shares ISA, you need to make sure your account is paying out the proceeds to you.
You’ll usually need to amend your account settings so that all dividends and income received is paid to your bank account. Otherwise, they’ll either be automatically reinvested or will just sit in your ISA as cash until you manually move them.
You can usually change your account settings online, via your provider’s app, or over the telephone.