A Stocks and Shares ISA is a tremendous vehicle for building wealth in the stock market. That’s because its gains (share price rises and dividends paid) are tax-free.

With annual tax allowances being slashed aggressively next year, the power of an ISA is increasing. And to maximise its potential, I think investors should strive to inject as much as the £20k annual limit as possible.

However, even if an investor can spare £20k each year, the next challenge is figuring out where best to invest it. So if I were building an income ISA portfolio from scratch today, here’s how I’d go about it.

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.

Quality over quantity

If my goal is to build a lifelong second income in the stock market, targeting the companies with the biggest payouts sounds sensible. After all, the higher the yield, the greater the return, and the faster I grow my ISA, right?

Income investing isn’t that simple. While there are some exceptions, a high dividend yield is often a sign to stay away. Why? Because this metric can be easily manipulated by a rapidly falling stock price rather than an increase in shareholder payouts.

This creates income traps where an investor buys a dividend stock for passive income only to see payments slashed, or outright cancelled, a few months later. So if yield isn’t the answer, what is?

Cash flow. Specifically free cash flow to equity (FCFE). This is the money left over after a company has covered all of its operating, reinvestments and debt servicing expenses. In other words, it’s the capital a firm has available to:

• Accumulate as cash on the balance sheet
• Buy back shares
• Pay a dividend

By comparing the dividends paid to the FCFE, investors can quickly gauge if a company is generating enough money to afford its payouts. Suppose dividends are getting close to or exceed the FCFE? In that case, they may be at risk of going on the chopping block if cash flow gets disrupted.

Diversifying a portfolio

Even if an investor finds a terrific company with sustainable-looking dividends, there’s no guarantee it will stay that way. External disruptions can emerge with little warning. This can send even the best cash-generative businesses into becoming far more conservative with shareholder payouts.

That’s why diversification plays a critical role in building an income portfolio. By owning a variety of top-notch enterprises across multiple industries and geographies, the impact of one firm getting disrupted is mitigated by the others.

Even the most diversified ISA in the UK isn’t risk-free. Stock market crashes and corrections can smash valuations into the ground. However, historically diversified portfolios containing high-quality shares usually fare better and recover faster.

And the large number of millionaires who’ve made their money via their ISAs shows just how rich the rewards can be for investors who choose wisely.

The post Where to invest £20k in a Stocks and Shares ISA to earn extra income for life appeared first on The Motley Fool UK.

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More reading

• How I’d turn a handful of dividend stocks into a lifelong second income!
• 2 dirt cheap FTSE 100 shares I’ve bought to hold for 10 years
• 3 tactics to beat a volatile stock market
• Building a £100k ISA from scratch
• Is Hargreaves Lansdown the best growth stock on the FTSE 100? Here’s what the charts say

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.