With £20k in an ISA, here’s how I’d aim to turn it into a £6,800 second income

Fancy earning a tax-free second income? Well, one method to achieve just that is by leveraging the power of a Stocks and Shares ISA.

This special type of investing account removes capital gains and dividend taxes from the wealth-building equation. And once enough wealth has accumulated, it’s possible to earn a pretty chunky passive income, stretching into the five-figure territory.

Earning dividend income

Dividend stocks are typically more mature, paving the way for lower volatility. But best of all, investors get paid every so often simply for holding shares in their portfolio. In other words, it’s possible to make money while sleeping soundly each night.

So how much passive income can a £20k ISA generate? On average, British dividend stocks typically offer a yield of around 4%, or £800 a year. But there are businesses offering considerably more. And without taking on too much extra risk, earning a yield closer to 6% could boost this annual second income to £1,200.

While that’s certainly nice to have, it’s hardly life-changing. Yet, if left to run, it could be. Instead of taking the income from day one, investors can opt to automatically reinvest dividends back into the business that paid it.

That means a portfolio will have even more shares the next time dividends are paid. This value-building loop continues until an initially small second income grows into something far more substantial.

Sustainable double-digit yields

All too often, novice income investors rush to find the biggest yields in the stock market. However, in the long run, that may be a critical error. The most lucrative income stocks aren’t the companies that pay chunky dividends but rather the ones that can keep raising them.

A perfect example of this could be Safestore Holdings (LSE:SAFE). The self-storage operator isn’t a particularly fancy enterprise. However, it operates at relatively low costs and generates monthly cash flow primarily through rent collection from its customers.

As it’s expanded its self-storage empire as well as increased rental prices ahead of inflation, the firm’s delivered fairly consistent revenue and earnings growth. And that’s culminated in 15 years of consecutive dividend hikes.

Back in 2009, Safestore’s shares only had a yield of 3.3%, which was firmly below the market average. However, those who held on through thick and thin for the last decade and a half are now earning a yield of over 21%.

That means £20,000 invested back in 2009 is now generating roughly £4,200 a year. And if all dividends were reinvested over this period, the income from all the extra shares actually pushes the yield higher to a whopping 34%, or £6,800!

Every investment carries risk

Safestore’s historical performance has been quite extraordinary. Sadly, that doesn’t guarantee this trajectory will continue in the long run.

With interest rates now much higher compared to the last 15 years, Safestore’s earnings have started feeling some pressure from the debt on its balance sheet. And while the firm currently generates more than enough to cover its interest expense, that’s still less money available to fund higher dividends.

Occupancy also plays a critical role in cash flow generation, which can be a bit cyclical depending on economic conditions. Nevertheless, the firm serves as an excellent example of what a successful dividend-growth investment can deliver in the long run.