A common goal among stocks and shares ISA investors is to create a passive income stream. And this desire has only intensified in the wake of the cost of living crisis hitting the UK.

With both capital gains and dividends earned within an ISA exempt from tax, this investment vehicle has become one of the most powerful wealth-building tools in Britain. And in the long term, even an initially modest portfolio can become transformative.

In fact, those with £7,000 in the bank can already get the ball rolling and begin their journey to earning £5,000 a month passively and tax-free.

Please note that tax treatment depends on each customer’s individual circumstances and may be subject to change in the future. The content of this article is provided for informational purposes only. This is not tax advice nor does it constitute any form of tax advice. Readers are responsible for carrying out their own due diligence and obtaining professional advice before making any investment decisions.

Analyze the numbers

A monthly passive income stream of £5,000 equates to £60,000 per year. This is almost double the current median salary in the UK. So how big does a portfolio need to be to generate such an income stream? Unfortunately, the answer is around £1.5 million.

Although investors can change the 4% withdrawal rule to try to reduce the required portfolio size, investors will likely still need a seven-figure Stocks and Shares ISA to sustainably earn £60,000 a year. But as daunting as it may seem, the journey to £1.5million is not as impossible as it seems.

Suppose a portfolio can generate an annualized return of 10%, roughly in line with the stock market average. How long would it take for £7,000 to turn into £1.5 million? A little over 53 years old.

It’s certainly doable for younger people, but not so much for the older generation. Fortunately, this journey can be significantly shortened by injecting a little extra capital each month. On average, UK households save around £450 per month. But if that money was redirected into a 10% yielding portfolio, the journey to an annual tax-free ISA income of £60,000 would be shortened to just under 33 years – two decades faster.

What is the trap?

Even with additional monthly investments, the success of a portfolio ultimately depends on the return it generates. Index Trackers are a great tool for replicating the performance of indices like the FTSE100 And FTSE250. However, in recent years, even after the 2024 market rally, these indexes have struggled to keep up with their historical performance.

In other words, investors might have to wait much longer than expected when relying on index funds. This is why selection of titles remains my favorite strategy. There is no denying that investing directly in individual companies carries significantly higher risks. In addition to requiring much more discipline, research and knowledge, custom portfolios also tend to be more volatile.

However, it also opens the door to investing in market-beating and potentially game-changing opportunities. Ashtead(LSE: AHT) a great example of this. The equipment rental group’s management team has demonstrated a talent for capital allocation and international expansion. Subsequently, the company became the UK’s best performing stock over the past 20 years.

Since November 2004, shareholders have reaped an average annualized return of 27.3%, including dividends. And at this rate, the journey to £1.5 million would only take 15 years! Unfortunately, Ashtead’s massive expansion likely means that the days of annual returns close to 30% are now over for new investors.

But it shows the potential of picking winning stocks over the long term. And for investors wanting to passively earn £5,000 a month, these are the kind of opportunities that will make that dream a reality.