The Stocks and Shares ISA is one of the most important tools for investing. That’s simply because it allows us to earn a passive income and realise share price gains, without paying any tax.

And, naturally, this makes it an excellent vehicle for our investments. So, here’s how I can use the Stocks and Shares ISA to create a tax-free second income.

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.

Passive income from a lump sum

When considering any venture, having an initial capital foundation undoubtedly streamlines the process. The Stocks and Shares ISA allows me to save up to £20,000 every year. With this money, I can start investing.

There are two strategic pathways to explore within this framework:

• First, I can opt to allocate my funds into dividend-paying stocks right away, leveraging their immediate income potential. Currently, I’m spoilt for choice when it comes to dividend picks. Remarkably, there are around 60 stocks listed on the FTSE 350 that boast dividend yields surpassing the 6% yield threshold. This figure is notably substantial, indicating a considerable range of choices available to explore.

• Alternatively, I have the option to focus on nurturing my portfolio’s growth, harnessing the power of compound returns to gradually cultivate a larger investment base. This approach sets the stage for eventually reaping a passive income at a later point, ensuring a well-considered and strategic progression in my investment endeavours.

Starting from scratch

Many of us won’t have that starting capital. And this means we’ll be investing for a long run. Navigating this path necessitates a disciplined mindset coupled with consistent and periodic savings practices.

Yet, it’s crucial to acknowledge that through a consistent effort, a meticulously planned compound returns strategy, and the passage of time, the potential exists to transform a modest monthly contribution into a substantial income stream.

Compound returns work when I reinvest my earnings every year, thus allowing me to earn interest on my interest as well as my contributions. This means the growth is exponential. It can be likened to a snowball rolling down a hill, collecting more snow and growing larger as it moves.

Hence, the longer I invest for, the faster it grows. And the larger it gets, the more interest I can receive in the form of dividends.

The key to dividend investing

Embarking on the journey of dividend investing is far from a straightforward pursuit limited to selecting stocks with the highest yields. Dividends are by no means guaranteed.

And this means we, as investors, need to do our homework. Huge dividend yields can be a warning sign, and these are the stocks that carry a heightened risk of cutting, or halting, dividend payments.

While it’s worth highlighting that some stocks, such a Legal & General, almost exclusively reward shareholders with dividends, rather than share buybacks, it’s worth being wary of very big yields.

Instead, we may wish to turn our attention to those stocks with moderate, stable yields — with strong dividend coverage and a track record — instead of those that could be at risk.

As such, some of the most appropriate dividend picks could be Lloyds, with its 5% yield, or Hargreaves Lansdown, which offers a very similar return. These yields, as they stand, look affordable.

The post How to create passive income within a tax-free Stocks & Shares ISA appeared first on The Motley Fool UK.

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James Fox has positions in Hargreaves Lansdown Plc and Lloyds Banking Group Plc. The Motley Fool UK has recommended Hargreaves Lansdown Plc and Lloyds Banking Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.