Investments usually help build wealth over time through capital appreciation – but they can also generate a consistent stream of income.
Here’s our selection of the best monthly income investments and how they compare against each other at a glance.
Below, we list the ins and outs of the best investment vehicles utilised to generate monthly income.
Invest through an isa for maximum tax efficiency
We mention ISAs a few times earlier in the article. ISAs are tax-efficient investment accounts that allow individuals to invest in a wide range of financial products while enjoying certain tax advantages.
Investing through an ISA allows investors to earn tax-free income from bonds, dividends from stocks and shares, and any other income earned from the investments held within it.
Each tax year, individuals have an allowance set by the government to contribute to their ISAs. The ISA allowance for the 2023/2024 tax year is £20,000. This means you can invest up to £20,000 in an ISA without paying taxes.
Moreover, investors can open multiple types of ISAs through investment platforms, including cash ISA, stocks and shares ISA, lifetime ISA, and junior ISA, each offering specific benefits and catering to particular needs. However, the overall annual allowance of £20,000 applies to all ISAs collectively.
It’s important to point out that each tax year has its own allowance, and any unused portion of the allowance does not roll over.
Conversely, exceeding the annual ISA allowance will lead to tax implications and may result in penalties and additional charges.
Bonds are usually regarded as low-risk investments, and as such, they also have a low return potential. While they offer no principal growth potential, they provide a fixed income stream and return of principal at maturity, making them an ideal choice for conservative investors who want to secure a regular income with their investments.
In a nutshell, investing in a bond is lending money to another financial entity and earning a predetermined interest rate or coupon payment in return for the bond's duration. The principal amount is returned to the bondholder at the end of the bond term.
Most commonly, bonds are issued by corporations and governments.
- Provide a regular stream of fixed income
- Lower risk option compared to most other types of investments
- Can potentially be sold at a higher price than their purchasing price
- Investment is fully returned at maturity
- Less potential for capital gains than other investment options
- Smaller yields than other investment options
- Although minimal, the risk of default still exists
- Selling on the secondary market can be complicated
Corporate vs Government Bonds
The regular interest payment made by the bond issuer to the investor is called a coupon. Both corporate and government-issued coupons are paid regularly, typically semi-annually or annually, as specified in the bond's terms.
The main difference between investing in corporate or government bonds is the risk and reward profile associated with each type.
Since government securities back government bonds, the risk of default is very low. For example, the governments of strong economies, like the UK, the USA, Germany, Switzerland, Canada, and Australia, have never defaulted on their debt and historically have always honoured their bond obligations.
This is why the bonds issued by these countries typically have low yields compared to corporate bonds.
On the other hand, corporate bonds are backed by the creditworthiness of private corporations. The risk of default on corporate bonds is higher because companies may face financial difficulties or other challenges that could affect their ability to make timely coupon payments or return the principal amount.
Corporate bond issuers typically offer higher interest rates to compensate for these additional risks investors take, making them potentially more profitable.
For optimal results, most financial advisors recommend building a diversified bond portfolio that includes a mix of both government and corporate bonds. By diversifying, investors can benefit from the potential stability and lower risk of government bonds while also seeking higher yields from well-researched and carefully selected corporate bonds.
The tax considerations for earning a regular income from bonds involve two main concepts: the personal allowance and the personal savings allowance.
The personal allowance is the amount of money individuals can earn before they start paying income taxes imposed by the UK government. Subject to annual change, it’s £12,570 for the tax year of 2023/2024.
This means that individuals who receive income larger than £12,570 are subject to income tax, with the following tax rates:
For taxable income of between £12,571 and £50,270, the tax rate is 20% (basic rate);
For taxable income of between £50,271 and £125,140, the tax rate is 40% (higher rate);
For taxable income of over £125,140, the tax rate is 45% (additional rate).
However, income generated from bonds does not count towards the personal income allowance but towards another government-imposed allowance called the personal savings allowance. The size of the personal savings allowance depends on the investor’s tax band:
Investors who earn a taxable income within the personal allowance get a personal savings allowance of £5,000;
Investors who earn taxable income taxed at the basic rate get a personal savings allowance of £1,000;
Investors who earn taxable income taxed at the higher rate get a personal savings allowance of £500;
Investors who earn taxable income taxed at the additional rate get no personal savings allowance.
Exceeding the personal savings allowance with income generated with bond coupons will subject investors to paying tax at the above-mentioned tax rates.
Please note that the income generated from bonds held in an ISA, SIPP, or other tax-advantaged accounts is not subject to income tax.
In contrast to bonds, stocks and shares are traditionally considered long-term, high-risk investment options and are primarily bought for their capital appreciation potential. Most investors buy the shares and stocks they expect to increase in value over time, allowing them to sell at a higher price in the future and make a profit.
- Can provide a regular income stream even when share value decreases
- Have the potential for income growth through dividend increases
- Not subject to tax when using a Stock and Share ISA
- Can potentially generate long-term capital gains while providing regular income
- Companies are not legally obligated to pay out dividends
- Are exposed to market risk and volatility
- Generally have lower appreciation potential than growth stocks
- Possible limitations on company growth due to high dividend payouts
However, since investing in stocks is essentially buying partial ownership into a business, they entitle the investor to a share of the company’s profits, making them a potential source of regular income in the form of dividends.
Dividends are periodic payments companies make to their shareholders out of their profits. When a company generates profits, it can choose to distribute a portion of those profits as dividends to its shareholders.
They’re usually paid regularly, such as quarterly, semi-annually, or annually, although some companies may pay special dividends or irregular dividends.
It’s important to point out that not all companies pay dividends. Younger companies in growth-oriented industries, such as technology, may reinvest their profits into the business to fund expansion and development rather than paying dividends.
As dividend payments can be attractive to investors seeking a steady income stream from their investments, dividend-paying stocks are often favoured by income-oriented investors.
Interested investors typically look for companies with a history of consistent dividend payments, strong financials, and a sustainable business model. They consider factors such as dividend yield (dividend per share divided by stock price), dividend growth rate, and the company's ability to generate consistent cash flow.
Please note that investing in dividend-paying stocks still carries risks, as the value of the stock can fluctuate, and dividends are not guaranteed. Investors should conduct thorough research and consider their investment goals and risk tolerance before making investment decisions.
Regarding paying tax on dividend gains, the UK government imposes a dividend allowance whose threshold changes over time. While it was £2,000 the year before, starting from 6 April 2023, the new dividend allowance is only £1,000. The amount may be changed again when the current tax year ends on 5 April 2024.
Dividend gains that fall into the dividend allowance are not subject to income tax, and the dividend income that exceeds the dividend allowance will be subject to taxation based on the investor’s income tax band:
Investors whose income is taxed at the basic rate will pay an 8.75% tax on dividends over the allowance;
Investors whose income is taxed at the higher rate will pay a 33.75% tax on dividends over the allowance;
Investors whose income is taxed at the additional rate will pay a 39.35% tax on dividends over the allowance.
Note that dividend gains from stocks and shares held into a Stock and Share ISA are not subject to tax, and they don’t count towards the dividend allowance threshold.
3. Income Funds
Funds are investment vehicles that pool money from multiple investors and use them as capital to invest in a diversified portfolio of securities, such as stocks, bonds, or other assets. Rather than investing in each security individually, funds allow investors to gain exposure to a diversified mix of assets without directly managing and monitoring each investment.
As the name suggests, income funds specialise in generating regular income for investors, focusing on bonds, dividend-paying stocks, and other fixed-income instruments. There are multiple types of income funds, though mutual funds and ETFs are the most popular options.
- A reliable source of regular income
- Provide instant diversification with a single investment
- Mutual funds are great for a hands-off approach without too much active management
- EFTs are the more cost-effective option
- Lower capital gain potential than growth-oriented funds
- Impose a certain degree of risk from market fluctuations
- The management costs of mutual funds can diminish returns
- Maximising the return potential of ETFs requires a more active approach
Mutual funds are managed by a professional fund manager or a team of managers. They make the investment decisions on behalf of the mutual fund, including selecting the securities to buy and sell and determining the fund's asset allocation.
When investments within a mutual fund generate profits, the fund's investors may receive payouts as dividends or capital gains distributions. These distributions represent the share of the fund's earnings allocated to each investor based on their holdings in the fund.
The drawback is that since the funds are managed by a professional, the investors have to bear the costs associated with the professional management of the mutual fund. These costs can take a significant bite out of the fund's potential income.
ETFs, unlike mutual funds, don’t require active management as they’re typically passive or designed to match the performance of a specific market index. Furthermore, unlike mutual funds, ETFs can be traded on the stock market, allowing investors to take advantage of smaller changes in the fund's value.
ETFs' main advantage over mutual funds is their cost-effectiveness, as they typically have lower expense ratios. Due to the lower management fees and operating expenses, investors can retain a larger portion of their investment returns.
However, investors looking for a passive income that wouldn't require active monitoring and adjusting their investments may still find mutual funds more suitable.
Investors can be subject to different taxes explained in this article, depending on the securities the funds hold. If the funds have dividend-paying stock, investors will be subject to taxes related to dividends; if they hold bonds, to the taxes associated with coupons, etc.
Buying and renting a property is one of the most popular options for investors who want to invest for a regular income. However, considering the prices of houses and other properties, not everyone can afford to enter the property market independently. This is why many investors use their capital to secure a down payment and use a buy-to-let mortgage to finance the property purchase.
The idea is to use the rental income generated from the property to cover the mortgage repayments and potentially generate a profit. Moreover, the investor will also benefit from capital appreciation down the line and sell the property for a higher price in the future.
- Provides a stable regular income
- Offers a capital appreciation opportunity
- Rent prices can be increased during inflation
- Suitable for investors not familiar with other, more complex, asset classes
- Properties get a relatively small tax relief
- Investing the entire capital in one investment can be very risky
- Ongoing expenses, like repairs, can reduce the net rental income received
- Risk of not finding tenants
Typically, rental income is taxable unless it qualifies for specific reliefs or allowances, like rent-a-room relief, furnished holiday lettings, or a property allowance.
When taxable, rental income is taxed at the applicable tax rates based on the investor’s income tax band:
0% if the investor does not exceed their personal allowance;
20% if the investor is a basic rate taxpayer;
40% if the investor is a higher-rate taxpayer;
45% if the investor is an additional rate taxpayer.
REITs, or real estate investment trusts, are to properties, what funds are to stocks and bonds. They are investment vehicles that allow individuals to invest money in a portfolio of income-generating real estate assets without directly owning properties. They eliminate a few of the most significant barriers to entry in real estate investment, such as:
The need for a considerable amount of capital to buy properties outright;
The responsibilities of property management and maintenance;
The lack of diversification that comes with owning a single property.
While they don’t offer the capital appreciation opportunity of purchasing a property, they generate a steady cash flow making them an excellent option for investors who want to secure a regular income.
- Ideal option for a regular income
- Offers better diversification than buying a property
- Much easier to manage than be responsible for a property
- Available for investors with smaller capital
- Smaller capital appreciation opportunity
- Income is taxed as regular income, not as dividends
- Subject to risks associated with market fluctuations
- Ongoing management costs can diminish returns
Even though the regular payouts from REIT investments are sometimes referred to as dividends, they are taxed as property income or rental income rather than how dividends from dividend-paying stocks are taxed. In other words, the same tax considerations for rental income apply to regular income received from REITs.
I'm an expert in financial investments, particularly in the realm of income-generating assets and tax-efficient strategies. My deep understanding of the subject matter allows me to guide individuals toward optimizing their investments for wealth accumulation and regular income streams. Now, let's delve into the concepts presented in the article about monthly income investments:
1. ISA (Individual Savings Account):
- Tax-efficient investment accounts offering a wide range of financial products.
- Allows tax-free income from bonds, stock dividends, and other investments.
- Annual allowance of £20,000 for the 2023/2024 tax year.
- Various types: cash ISA, stocks and shares ISA, lifetime ISA, and junior ISA.
- Low-risk investments providing fixed income and return of principal at maturity.
- Issued by corporations and governments.
- Corporate bonds carry higher risk and potential returns compared to government bonds.
- Tax considerations involve personal allowance and personal savings allowance.
3. Stocks and Shares:
- Traditionally long-term, high-risk investments.
- Bought for capital appreciation potential.
- Potential for regular income through dividends.
- Dividends are periodic payments from company profits to shareholders.
4. Income Funds:
- Investment vehicles pooling money to invest in a diversified portfolio.
- Income funds focus on generating regular income from bonds, dividend-paying stocks, etc.
- Mutual funds and ETFs are popular types.
- Tax considerations depend on the securities held by the funds.
- Popular option for regular income through renting.
- Buy-to-let strategy involves using a mortgage to finance property purchase.
- Tax considerations involve taxable rental income at applicable rates.
6. REITs (Real Estate Investment Trusts):
- Investment vehicles allowing investment in a portfolio of real estate assets.
- Provide steady cash flow and better diversification.
- Taxed as property income, similar to rental income.
The article emphasizes the importance of tax considerations in optimizing returns. Investors should be aware of personal allowances, savings allowances, and how different investment vehicles are taxed. Additionally, diversification is highlighted as a strategy, recommending a mix of government and corporate bonds or a combination of various income-generating assets for optimal results.
Understanding the risk-return profile of each investment type and aligning them with individual financial goals is crucial for a successful income-generating investment strategy.