The ability to invest up to £20,000 a year in an ISA and not pay a penny of tax on the passive income it can generate can be life-changing.

In the 2023/24 financial year, the last year for which we have data, British adults had 15 million ISA accounts. The total amount of money invested in ISA accounts was £103 billion! So we are a nation of astute savers and investors, right? Well, we need to dig a little deeper.

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.

Choose the right one

Of these 15 million ISAs, 9.9 million are cash ISAs and just 4.1 million are stocks and shares ISAs. There was £69.5 billion in the Cash ISA, but only £31.1 billion – less than half of that amount – went into the Stocks and Shares ISA.

Cash ISAs can be a great way to secure emergency cash or short-term savings. And for people who don’t really want any stock market risk at all, guaranteed returns are a safer option. However, in the longer term, the Stocks and Shares ISA has wiped the floor with the Cash ISA alternative.

Top Cash ISA interest rates are currently just above 4%. And that’s actually not that bad. However, over the last 10 years the average annual return on stocks and shares ISAs has been a whopping 9.6%.

The difference it can make

The total amount we will need to raise depends on the rate of return we can achieve.

Of this, the 9.6% return on the Stocks and Shares ISA of around £132,000 should generate enough passive income to cover our target of £1,000 per month. By investing £500 a month and reinvesting all the dividends, we could achieve this in 12 years.

To do the same with a 4% Cash ISA return we would need over £320,000. At this interest rate it should take 29 years to build.

To be fair, that 9.6% of shares were above average for stocks overall. However, 4% cash will not be sustainable when Bank of England (BoE) rates fall. I can easily see Cash ISA rates falling below the BoE’s 2% inflation target. To earn £1,000 a month at a 2% rate of return, we’d need over £600,000 – and 56 years to get there.

Stocks worth considering

Legal and general (LSE: LGEN) currently forecasts a dividend yield of 7.9%. This alone, provided we buy fresh dividend stocks every year, can go a long way in helping us achieve our passive income goals.

The dividend is not guaranteed, although in the first half results the company actually indicated that it was paid “over £5 billion in dividends and share buybacks over three years“

The share price has only increased by a modest 3.7% over five years. In fact, after a previous period of growth, it has not changed much in ten years. But for me, the share price boost on top of my dividends is really just a bonus.

The insurance and investment sector is a risky sector. And increases and decreases should be expected depending on the mood in the global economy and stock markets. However, as part of a well-diversified long-term portfolio, Legal & General is one stock I think those looking for passive income should consider.