What makes a Stocks and Shares ISA a potentially useful tool for generating passive income?

A few things in my opinion. As I’ll explain below, with the right approach, an ISA can provide powerful streams of passive income.

Why bother with an ISA?

Some passive income ideas are pretty crazy. Some are not passive at all, but require a lot of work.

In turn, investing in shares of proven blue-chip companies that pay dividends from the free cash flow they generate can potentially provide true passive income. I say “potentially” as dividends are never guaranteed. However, in my opinion you can manage the risk by spreading your ISA across a range of different, carefully selected stocks.

However, this approach does not require an ISA. All you need is a uncomplicated stock trading account or trading app. The advantage of a Stocks and Shares ISA is that dividends can be accumulated tax-free.

By taking a long-term approach, they can be reinvested (cumulative) so that the dividends can generate more dividends over time.

Please note that tax treatment depends on each client’s individual situation and may change in the future. The content of this article is for informational purposes only. It is not intended to be and does not constitute any form of tax advice. Readers are responsible for conducting their own due diligence and obtaining professional advice before making any investment decisions.

Five-digit passive income potential

As an example of how lucrative this can be, let’s say someone invests their Stocks and Shares ISA at 7% per annum. After 35 years it should be vast enough that the dividend yield of 7% will equal the pound14947 year of passive income.

However, this raises two questions: why wait so long and is the 7% target realistic?

A long-term approach can pay off

Waiting 35 years gives your application enough time to make a real financial impact. That’s why passive income is so impressive.

But you don’t have to wait 35 years. The same approach could work over a much shorter (or longer) time horizon. However, the income earned will vary accordingly depending on the time frame.

Hunting for quality stocks to buy

What about the target compound annual growth rate of 7% and the dividend yield thereafter? (The difference, by the way, is that the compound annual growth rate includes not only dividends, but also any capital gains minus any capital losses). I believe 7% is realistic.

One stock I think investors should consider is ITV (LSE: ITV). It intends to pay a dividend of at least 5 pence per share each year. The stock is currently selling for pennies, so its dividend yield is 6.1%. This means that for every £100 invested, the investor will earn £6.10 a year in dividends.

In addition to the earning potential, I also see some potential for the ITV share price to augment over time. This would be a change from what we have seen in recent years. The stock has lost 31% of its value over the last five years.

Such a decline reflects a risk that remains concerning: the impact of growing digital competitors and changing media consumption trends on the legacy broadcaster.

I consider it a risk. However, ITV’s legacy business remains a solid foundation for its business, even if it declines over time.

The company is also expanding its digital business. It also has a sizeable production operation providing studio space and expertise. In my opinion, the current share price underestimates the long-term value of this combination.