Get to know Tessa - the easiest tax break in town

Click to follow
It Is probably the easiest tax break you can find: save pounds 9,000 over five years, then draw the interest tax-free, roll over the capital and start again. Millions of savers will immediately recognise her from the introduction: Tessa, the friendliest tax-free savings account you can meet.

Opening a Tessa is simple: walk into any bank or building society and 10 minutes later your account can be up and running.

Tessa stands for tax-exempt special savings account, and the name tells you almost everything you need to know.

Tax-exempt means just that: you do not have to tell the taxman about the account - even that it exists - unless you close it, make an early withdrawal, or otherwise break the rules. Special means there are specific conditions governing the account. These are of two kinds: those concerned with its tax status and those that are the bank or building society's own terms and conditions. Savings account is perhaps the most important part of the name - but it is often misunderstood.

Because of their tax-free status, some people think that Tessas, like PEPs, must involve an element of risk. In fact, they are as safe as any other kind of deposit account. There is no risk to your capital and in the unlikely event that the institution fails, you will get your money back thanks to the Investors Compensation Act.

With more than pounds 30bn invested, Tessas are one of the most popular forms of savings plan. When they were introduced almost six years ago, the Government hoped that their tax-free status would encourage people to increase their savings. That hasn't happened, according to a report this year by Mintel, a respected market research company. It found that a majority of deposits in Tessas came from "switch savers" - those who moved their money from other accounts to take advantage of the tax break. Charles Adrienssens, Mintel's financial analyst, said: "Tessas have been one of the success stories of the 1990s as far as attracting deposits has been concerned. But they have not managed to encourage the smaller saver. That was the Government's original aim."

Whether transferring money from an existing, tax-paying account, or making regular savings from salary, you need to be aware of the limits onTessas. First there is the maximum investment of pounds 9,000. Within that limit there are restrictions on how much you can invest each year. In the first year you can deposit up to pounds 3,000. Thereafter you can put in up to pounds 1,800 a year, except for the final year, when the limit is pounds 1,800 or whatever lower amount will take you to the pounds 9,000 ceiling. (Different limits apply for second Tessas - those being used to roll over funds from a first Tessa.

There are also limits on withdrawals. You cannot touch the capital until the end of the five years, but you can - subject to the rules of your particular account - withdraw up to 80 per cent of interest earned since April this year, and up to 75 per cent of interest earned before that date.

If this sounds strange, remember that the Tessa is tax- exempt. The amount of interest that you have to keep in the account until the term is up is what you would have to pay in tax if the money were held in a standard, taxable account.

Most Tessas offer variable rates, and the market is highly competitive, so it pays to shop around. But if you are comparing Tessa rates with those available on other deposit accounts, remember they are tax-free, so a Tessa paying 7.5 per cent is comparable with a standard account paying 10 per cent gross.

When Tessas were invented, they were intended not only to promote savings growth, but also to promote increased competition. Investors would be able to compare the interest rates offered by different institutions and move to the one offering the highest.

That was the theory, but it has not quite worked out like that. The banks and building societies seek to retain your business in two ways: with loyalty bonuses if you keep the account for the full five years, and penalties if you do decide to transfer. Some of these penalties can be as much as 180 days' interest.

So if you are the kind of active saver who chases the best rates, you will need to include the penalties in your calculations.