In 2026, investors can instantly unlock a new tax-free passive income stream by using a Stocks and Shares ISA.

This powerful wealth-building tool allows individuals, even those with small amounts of capital, to buy shares in the stock market without having to worry about HMRC knocking on the door. And what’s more, when left to run, an initially small dividend income stream can compound into something far more substantial.

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.

Turning £7,000 into an income stream

The FTSE 100 is home to the largest businesses on the London Stock Exchange. And right now, investors can snap up shares in a cheap-and-cheerful index fund to instantly start earning a 2.9% yield from dividends.

In other words, investing £7,000 this way unlocks a £203 annual passive income overnight.

That’s not bad. But it’s not exactly ground-breaking. Luckily, for stock pickers, the passive income opportunities are far more exciting.

Take Legal & General (LSE:LGEN) as a prime example to consider. By investing directly in this FTSE 100 insurance giant, shareholders can earn a far more impressive 8.1% yield.

That’s enough to generate a £567 income from the same £7,000 investment. And considering this business has hiked shareholder payouts every year since 2009 (excluding the 2020 pandemic), this passive income could expand even further over the long run.

Where’s the risk?

Earning a near-8% yield is undoubtedly exciting, especially when it’s being driven by payout hikes rather than rapid drops in the share price.

However, when a stock is offering almost triple the yield of its parent index, that does set off some alarm bells. Why? Because it typically signals significant risk.

In the case of Legal & General, there are some valid reasons for caution. Core operating profits are currently insufficient to cover dividends, with the level of coverage dipping below 1.0, which isn’t great.

In other words, the company is currently having to use its own cash reserves to maintain shareholder payouts. While this is sustainable in the short term, if the business experiences a sudden cash flow disruption or conditions don’t improve, management may be forced to cut dividends.

In recent years, a core driver of earnings has been the lucrative pension risk transfer (PRT) market that burst back into life following the rapid rise in interest rates. But now that rates are falling again, it’s becoming harder to maintain these profits, especially since the level of competition in this space has also gone through the roof.

As a diversified insurance business, Legal & General isn’t solely reliant on the PRT market. And its Asset Management division is seeing some progress in expanding its fee-earning profit margins – an area where the business has enormous operating leverage given its £1.1trn of assets under management.

However, there’s no guarantee that these expected management fee profits will materialise as expected. So, where does that leave ISA investors?

The bottom line

For investors seeking to generate a passive income with a Stocks and Shares ISA, Legal & General shares present a classic high-risk, high-reward opportunity. If the company successfully bolsters the profitability of its asset management arm, earnings and further dividend hikes are likely to follow. But should it fail in this endeavour, the opposite might happen – a risk that investors need to carefully consider.