ISAs won't encourage more people to save

The Government's proposals for a new tax-free Individual Savings Account (ISA) to replace PEPs and Tessas were unveiled this week. ISAs have been heralded as Labour's mechanism for promoting a greater savings culture among the less well-off in our society. Nic Cicutti looks at what they mean and how you can maximise the options available to you.

What are ISAs?

The Individual Savings Account is the replacement for personal equity plans (PEPs) and tax-exempt savings schemes (Tessas). It will be introduced in April 1999. As with PEPs, income paid from the ISA will be tax free.

Gains on investments inside the ISA will also be tax free, allowing your capital to accumulate. In addition, the Government is proposing to pay a 10 per cent tax credit on dividends from UK equities for the first five years of the scheme.

How does the ISA compare with a PEP?

At present, you can invest up to pounds 6,000 a year in a general PEP, which can include corporate bonds. Additionally, you may invest pounds 3,000 in the shares of a single company. Other than the annual allowance, there is no upper limit on PEP investments.

Tessas allow a maximum investment of pounds 9,000 over five years, pounds 3,000 of which can be tucked away in the first year, pounds 1,800 in years two, three and four, and pounds 600 in the final year. They allow withdrawals with loss of tax benefits. Follow-on Tessas, which began to be offered in 1996, allow a maximum investment in year one of pounds 9,000.

ISAs will allow a maximum investment of pounds 5,000 a year. This can be a mixture of cash, shares and even insurance policies (see below).

There is no minimum, unlike most PEPs, which demand regular savings of at least pounds 25 a month. The Government expects that supermarkets and similar outlets will be prepared to set up ISA accounts into which even a few pounds can be paid.

Is there an upper limit on funds I can stash in an ISA?

Unlike PEPs, there will be a cap of pounds 50,000 on the amount that can be placed in ISAs. This is without time limit: if it takes 20 years to reach that amount, fine. Or if starting from scratch, you can do it in 10 years.

What else is different?

Again, unlike PEPs, you will be allowed to place up to pounds 1,000 of that pounds 5,000 annual allowance into a cash deposit account, with instant access. Withdrawals will not mean loss of tax incentives.

It will also be possible for up to pounds 1,000 of the ISA's annual allowance to be in the guise of an insurance policy, so that they too enjoy tax- free benefits. This is aimed at friendly societies.

What will happen to PEPs when the ISA comes in?

It will be possible to transfer all your PEP holdings into the ISA. The transitional period in which this is expected to happen is between 6 April and 6 October 1999. Transfers are subject to the pounds 50,000 upper ceiling.

Will transfers be easy?

The details have not been worked out. But PEP providers, together with banks, building societies and supermarkets, will be expected to apply to become ISA providers. The Government believes they will want to effect transfers for free.

The theory is that, as with PEPs, providers notify the Inland Revenue of subscriptions made. Investors will not be required to declare income or capital gains arising from ISAs on their tax returns.

What happens if I do not transfer my PEPs into the ISA before the transitional period ends?

The consultative document implies you will be subject to tax on capital gains from the April cut-off point. Income from a PEP will also be taxed at your marginal rate.

What happens if I have more than pounds 50,000 invested in PEPs?

Sorry, the most you can shift into the ISA is pounds 50,000. The rest probably will be subject to tax from April 1999.

What happens if I have a PEP mortgage?

Lenders calculate that regular premiums of about pounds 166 a month into a PEP/ISA (equivalent to the pounds 50,000 limit over 25 years) will be worth pounds 125,000 at maturity, assuming growth rates of 9 per cent.

This may prove insufficient for homes in London and the South-east of England and takes no account of sharp falls in equity prices over that period. Of course, couples would be able to use a double allowance.

Should I still invest in PEPs?

Yes, especially if you are a higher-rate taxpayer. Tax exemptions will apply between now and April 1999, including dividends paid in this period and you will be able to transfer into the ISA, subject to the limit.

What about Tessas?

The Government says you keep your Tessa to the end of its five-year life. Thereafter, you can can transfer the capital from it into the ISA, but not the interest, subject to the pounds 50,000 cap.

Will I be able to keep on paying into the Tessa after April 1999?

We don't know. If you start one now, you will be able to put in up to pounds 4,800 before April 1999. One potential problem is that only pounds 1,000 of each year's contributions can be held in cash. This appears to suggest that most Tessa holders won't be able to keep all their funds in cash after transfer.

Will ISAs encourage a greater "savings culture"?

It's doubtful. Generally, saving money requires a surplus of income over expenditure. Telling someone they will get an extra pounds 5 a year (compound) if they save pounds 30 a month for a year is unlikely to be enticing if they don't know where to find the money for their gas bill.