Different people have different goals when it comes to utilising a Stocks and Shares ISA. While I like the idea of owning shares that go up in value over time, I also appreciate the passive income potential offered by an ISA. By compounding dividends within the ISA, I can potentially set up a future second income stream in a tax-effective manner.

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.

Understanding how much income an ISA can generate

The size of the second income I might earn depends essentially on two things: how much money is in the ISA; and the dividend yield I could earn from it.

Even being aggressive about yield – say double the current FTSE 100 average, so 7.2% — investing my full £20k annual Stocks and Shares ISA allowance would earn me £1,440 in dividends a year.  That equates to a second income of £120 each month.

That would be welcome. But it is a long way from £1,000 a month!

How taking the long-term approach can help

Still, if I had the right timeframe I could hit that target even while putting no more than £20k a year into an ISA.

Say I (or any investor) put £20,000 into an ISA each year and it compounded annually at 7.2%, then after just six years it would have enough money in it that a 7.2% yield would generate over £1,000 in monthly income.

Indeed, although not necessarily using my full allowance each year, that is the approach I take. I could still get to a monthly £1,000 second income using it, although if I contribute less each year than in my example, it will take me longer.

Finding shares to buy

How realistic is a 7.2% compound annual gain? I think in the current market an investor could potentially achieve it while sticking to proven blue-chip shares. To reduce risk, diversifying across multiple shares would be a simple but smart approach.

As an example, one share for an investor to consider for their Stocks and Shares ISA is British American Tobacco (LSE: BATS). Its current yield of 7.1% is very close to my example. On top of that, the prospective yield may be higher if the tobacco maker keeps increasing its dividend per share annually as it has done since the last century.

Whether that happens, only time will tell. The company plans to keep growing its dividend but, in reality, no dividend is ever guaranteed.

One big risk here is that as fewer people smoke cigarettes in many markets, revenue and profit will decline at the company. Indeed, that is exactly what happened last year.

Still, the company is a massive cash generator and helps a lot of shareholders as they build a second income. Cigarette use is declining but remains substantial.

It is a business with high profit margins and the product’s addictiveness combined with British American’s premium brand portfolio gives it pricing power.