As the Individual Savings Account looms next year, Dido Sandler considers whether PEPs are still worth investing in for another 12 months

WHILE BOTH PEPs and Tessas, a tax-free deposit account, shelter your funds from income tax, PEPs also protect investments from capital gains tax (CGT). But the Government wants to attract an additional raft of new smaller savers and investors and will soon be launching the Individual Savings Account (ISA) as the new savings vehicle in succession to the two current schemes.

From April 1999, the ISA will allow pounds 5,000 of investments a year per individual, pounds 1,000 of which may be made up of savings deposits and a further pounds 1,000 of life assurance. Certain National Savings accounts may also be included.

If current proposals get the go-ahead, existing PEP investors will be able to transfer funds over to ISAs, and thus preserve their exemption from tax, but with an upper limit of pounds 50,000.

Holders of Tessas will be able fully to fund their accounts and keep them through to the end of the five-year term, if the account is started before April 1999. The capital from maturing Tessas may be switched into the ISA if the account's total capital remains within the overall pounds 50,000 limit.

The relatively low limit for PEP transfers has provoked uproar among the investment community. Clive Scott-Hopkins, director of independent financial advisers Towry Law Financial Services, accuses the Government of "unfair retrospective legislation".

Many blame the Treasury for punishing those who have been thrifty over the years, having the foresight to build up a sizeable tax-free nest egg. The Treasury believes 200,000 to 300,000 will be caught by the ISA cap on the maximum transfer. But Mr Scott-Hopkins says: "By the April 1999 the number could be considerably higher if the stock market continues its upwards drive. The FTSE 100 has risen by some 12 per cent since the beginning of the year."

The Treasury has been subject to intense lobbying by financial trade associations and PEP providers to lift both the upper transfer limit and the lifetime cap of pounds 50,000 on capital that any individual can put into ISAs. We will not know if the Government will take note of this until the Budget on 17 March, when the Chancellor, Gordon Brown, is expected to confirm details of the ISA rules.

Anyone with investments significantly below the pounds 50,000 limit should probably go ahead and continue to use their annual PEP allowance, as they have little to fear from the introduction of the ISA. Before parting with your money, you should, however, check with your PEP manager to see if they are planning to levy any charges for transfer from PEPs to ISAs next year. Most of the leading management groups such as Fidelity and M&G will make no charge for this.

"Individuals near or above the pounds 50,000 level with their existing PEP portfolio may want to wait until after the Budget before deciding whether to use up their this year's allowance," says Mr Scott-Hopkins. "There will be a window of opportunity between 18 March and 5 April, the end of the tax year, to purchase a PEP if they wish."

If the proposed limit does not change, he advises that lower-rate taxpayers may not find it so attractive to buy PEPs as opposed to other investments. Most investment trusts and a number of unit trusts have lower annual charges than those imposed by PEP managers for running their schemes.

But Paul Boni, investment director of independent financial advisers Berry Birch & Noble, says: "Whatever the outcome of the Chancellor's deliberations for individuals with sizeable PEP holdings, they should ensure they buy their 1997/98 quota. PEPs' capital gains tax-exemption may become more valuable, post-Budget, and PEPs can often be cheaper than the unit trusts that underlie them."

Many of the large PEP providers have initial charges of around 3 per cent, compared with 5 per cent if people invest straight into underlying unit trusts. If the worst comes to the worst, and Gordon Brown is intransigent on the pounds 50,000 transfer sum, one strategy would be to keep income stocks within the ISA, with any growth stocks outside the account.

This would be sensible because 99 per cent of the population have no CGT liability. And those with CGT to pay may be able to "bed-and-breakfast" their holdings, that is to sell and buy them back within the tax year, thereby diminishing their tax liability. Any such moves would depend on the post-March CGT rules. This strategy could be stymied if, for example, the Government dropped the individual allowance CGT allowance from the current pounds 6,500, below which individuals pay no tax.

Meanwhile, PEP providers, worried that the uncertainty over the investment vehicle's future will put off investors, are trying to make products as attractive as they possibly can. Royal & Sun Alliance, Gartmore, Perpetual and a number of others, have announced special discount offers to anyone taking out a PEP with them before the end of the tax year. Others, including Legal & General and Schroders, are stating that they will probably join them.

Many firms are guaranteeing existing customers that not only will they be able to convert their PEPs to ISAs free of charge, but if the pounds 50,000 limit is retained, they will also strip the PEP wrapper off unit trusts or investment trusts for free. In other words, they will not impose any exit charge if the PEP is unwound rather than being transferred.

Berry Birch & Noble 01905 775333; Gartmore 0800 289336; Fidelity 0800 414171; Legal & General 0500 116622; M&G 01245 390390; Perpetual 01491 416123; Royal & Sun Alliance 0500 111333; Towry Law 0345 868244.

Dido Sandler writes for `Financial Adviser'