Tax Tips: Make use of your last chance to pick up a Tessa

Tessas will remain attractive to investors up until 4 April 1999. Richard Shackleton explains why
Click to follow
Indy Lifestyle Online
Should investors kick Tessas (tax-exempt special savings accounts) out of bed now the Government has announced that they will be abolished to make way for the Individual Savings Accounts (ISAs) in April 1999? The short answer is no.

Tessa will keep her charm right up until midnight on 4 April 1999. Since 1991, thanks to the then chancellor John Major, Tessa holders have been allowed up to salt away up to pounds 9,000 out of the taxman's reach: pounds 3,000 in year one, pounds 1,800 in years two, three and four, and pounds 600 in year five.

Savers with a Tessa maturing after five years may reinvest the full pounds 9,000 capital into a follow-on Tessa, although they may not use the same route for reinvesting the income.

As they were designed to encourage long-term savings, the tax break on the interest applies only to money left in for the full five-year term, something that ISAs will aim to rectify with their open-ended investment terms.

Unlike an ordinary bank or building society savings account, Tessas usually pay a higher rate of interest, fixed over the life of the account. But with rates seemingly on the rise again this relative advantage has either narrowed or even disappeared altogether. Savers hoping to grab Tessas' higher rate for a few years might not be put off by this although they could be hit by the early withdrawal penalties imposed by many providers.

To compensate for the changing interest rate climate, some providers have brought out "escalator" Tessas, which give progressively higher rates. For instance, Woolwich pays 5.75 per cent in the first year, followed by 6.50 per cent, 7 per cent, 8 per cent and 9 per cent in years two to five.

Another innovation has been the equity-linked Tessa, which allows investors a limited exposure to the stock market, using derivative instruments tied to a UK market index, typically the FTSE 100. HSBC/Midland, Bristol & West, Birmingham Midshires and Abbey National all offer this sort of product. But equity-linked Tessas either have steep penalties if the money is needed before the five years are up or do not permit withdrawals at all. They also, of course, expose investors to risk.

So how should savers view the transition period between Tessas and ISAs? Under the current proposals, any Tessa started before 5 April 1999 will be allowed to run its full five-years, with no loss of tax breaks. Once the Tessa matures, savers will be able to transfer whatever they accrued in the account - although not the interest earned - into an ISA so long as the transfer does not take them over the proposed overall cap on ISA investments.

Savers will, therefore, fall into two camps: those who can transfer their Tessa cash into an ISA, and those who are caught out by the lifetime cap. However, and this is the key point, neither group will really be much worse off. Savers who can transfer their Tessa money without exceeding the ISA limit in are in exactly the same position now as they were before ISAs were announced.

Savers who think the lifetime cap will stop them transferring their Tessa cash into an ISA will still benefit from five years' tax-free interest. The only thing they will lose is the right to roll over their capital into a new, tax-free account.