Money: Government puts savers in quandary

How PEPs and Tessas can be adapted to the new accounts is far from clear. Clifford German explains

The Paymaster General has put the financial services industry in turmoil with his plan to rob rich investors and give to the poor by suggesting a lifetime limit of pounds 50,000 on holdings in the tax-free Individual Savings Accounts (ISAs) that will replace PEPs and Tessas in April 1999.

The argument has been spiced by accusations of bad faith. The Paymaster General, Geoffrey Robinson, argues that investors who have been rich enough to take up their full PEP and Tessa entitlements have enjoyed substantial tax-free advantages, and although they will only be able to transfer pounds 50,000 at current values, this will not mean they will be retrospectively taxed. But Howard Flight, deputy chairman of Guinness Flight Hambro and a Tory MP, dismissed the proposals as a complete sham as well as a contradiction of Labour's pre-election promises.

Interested parties have just eight weeks until the end of January 1998 to press their case for changes in the proposals. It promises to be a busy time, with tough bargaining needed to guarantee success. The annual limit of pounds 1,000 on the cash which can be put in an ISA is clearly too low. Even if supermarkets decide the idea of giving shoppers swipe cards to pay in cash when they do the weekly shopping is worth the hassle in the check-out queues, the amount of tax relief savers would get on a pounds 1,000 deposit would not buy a round of drinks.

One obvious attraction would be to expand the limited plans for free draws and increase the appeal to the gambling as well as the saving instinct. Rather richer savers might also think the pounds 1,000 limit on cash deposits in an ISA is not worth having. Although the money can be withdrawn without losing its tax benefits, the maximum holding is much too restrictive compared with the pounds 9,000 that can be put in a Tessa.

Others will argue that the inclusion of insurance premiums in ISAs is an unnecessary complication and will discourage many specialist providers from offering full-service accounts that can hold cash, policies and share- based investments.

But the biggest battles will be over extension of the annual and lifetime limits that will qualify for tax relief in future, and allowing more or even all existing PEP funds to be rolled over into an ISA.

Various transitional details remain to be clarified. Tessas started before April 1999 can probably be completed and maturing Tessas rolled into an ISA within the overall limit. But it is not clear if all PEPs will have to be rolled into a single ISA or can be split among a variety of managers.

Another issue that ISA providers must make clear is the level of charges. Investors will still have to pay charges, and it is essential that they should be transparent and simple. A flat management fee would be unattractive to small investors. A cash deposit might need to be subsidised by lower interest rates or higher annual percentage fees on share-based investments

Meanwhile, what if anything should investors be doing now? There is no obvious need to do anything immediately. Holders of Tessas can go on investing right up to 5 April 1999, subject to the current limit of pounds 9,000 and will retain their tax-free privileges outside an ISA until their accounts mature five years from the time they were started. It is possible that some investors might start a Tessa just before the deadline, but this will depend on the Government allowing all Tessas to go on building up for a full five years after April 1999.

PEP holdings should certainly be switched into an ISA in 1999 in order to take advantage of the 10 per cent tax rebate on UK share dividends available to all ISA holders until 2004. PEPs that have not been transferred to an ISA will lose their tax-free status on 6 October 1999, and will become liable both to income tax on dividends and to any capital gains tax which is due when they are sold.

The value of former PEP investments on October 1999 becomes the base for calculating future capital gains, not the date they were actually acquired. Even that could be a mixed blessing if by then we have a two- tier capital gains tax rate with a higher rate for short-term gains. There could be a case for investors with over pounds 50,000 worth of PEPs taking the biggest capital gains before the end of the tax year. But there is no need to act before the Budget.

PEP investors who are well under the lifetime limit will also want to know the final shape of the Government's plans in time to top up investments in the current tax year. If they are reassured, these investors might want to increase their holdings while they can still put away up to pounds 9,000 a year in order to get within striking distance of pounds 50,000 by the time the rules change and the annual amount they can invest is reduced.

But if the Government sticks to its ideological guns, investors who are already over the lifetime limit or expect to be within striking distance of pounds 50,000 by April 1999 will probably stop investing - unless they are convinced the stock market will rise appreciably over the next 18 months.

In the meantime, the search will certainly be on to find tax-efficient investments that can be held in addition to an ISA. Candidates in-clude second-hand or traded endowment policies, tax-free National Savings certificates and index-linked savings certificates as well as Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS).

The National Savings movement is also expected to launch a regular savings product specifically for inclusion in an ISA.

Offshore centres will also look more attractive for wealthy investors, although they are means to defer rather than avoid tax.