Tax planning: Shelter your savings

PEPs can offer the twin advantages of growth and no tax, writes Tony Lyons
Time is running out for personal equity plans (PEPs). From the start of the new financial year on 6 April, no new money can be put into a PEP. There is no need to be particularly concerned about this, as the Government is introducing ISAs in the next financial year and the general idea is the same. But if you have some money you would like to invest, PEPs are a good choice: over the long term, equities - shares - have produced the best returns for investors: better than building society accounts and other investments. Over the last 12 years around 4 million investors have used PEPs to accumulate almost pounds 50bn in savings, generating growth or income free of tax.

You can expect to see lots of tempting PEP offers over the coming weeks. Every adult can put up to pounds 6,000 in a general or self-select PEP and pounds 3,000 in a single-company PEP.

A self-select PEP is where you choose the individual shares and investments; a general PEP sees your money invested in a managed fund such as a unit or investment trust.

When ISAs arrive in April, you will be able to invest up to pounds 7,000 in the first year (pounds 5,000 per year after that) in a combination of equities, cash and life assurance.

The Chancellor has also changed the rules on advanced corporation tax (ACT), the tax paid by companies on dividends distributed to shareholders. Until 5 April, PEP managers will still be able to reclaim this tax on behalf of their investors - which makes the income from dividends tax free. For the next five years, only half the ACT can be reclaimed; and from 2004, the ACT will be paid in full. This will substantially reduce the income you get from a general PEP and stocks and shares ISA. For example, if your dividends currently amount to pounds 100 after ACT, the managers of your scheme will increase this to pounds 125 by reclaiming the full ACT. From 6 April, assuming no growth in dividends, they will only be able to reclaim an extra pounds 11. After 2004, you will receive just pounds 100.

If you want to maximise income, you should consider corporate bond PEPs, now offered by most leading groups. Payments on loan stocks (corporate bonds or gilts) are not affected by the rule change and will still be free of tax.

PEPs are best suited to higher-rate taxpayers, even if they remain in income funds. Even with the changes in ACT, they will still generate more income than direct investments as the rate of ACT is lower than the 40 per cent higher tax rate. From 6 April, non-taxpayers could also look to invest in ISAs, as they will be unable to reclaim any ACT themselves, while PEP and ISA managers will still be able to reclaim half.

Tracker funds, with their low costs, have shown over time that they outperform almost all actively managed funds, where the manager chooses the shares. Over five years, an active fund has a one-in-four chance of beating its benchmark stock market index (usually the FT-SE All Share for UK funds).

Trackers simply mirror either the FT-SE 100, which measures the performance or our largest 100 companies, or the much more widely based FT-SE All Share. If you do not want to take large risks with your investments, then you should look at FT-SE All Share trackers. More than half the total worth of British public companies is accounted for by just 15 blue chips in the 100 index. All, apart from BT, are in the financial, pharmaceutical and petrochemical sectors. This high concentration will increase the risk of losing money if the boom in these sectors stops.

Legal & General offers a good All Share tracker, with an annual charge of 0.5 per cent.

If you want to beat the stock market indices or fancy a flutter on Europe or elsewhere overseas, taking a slightly higher risk with your investment, then you should consider the active managers. Figures from HSBC show just over half (52 per cent) of European active funds have beaten their relevant benchmark index over the past five years.

Jason Holland of BEST Investment says PEP (and ISA) investments make sense, even if you aren't a higher-rate taxpayer: "Most unit trusts can often be bought cheaper through a PEP than by investing directly in the fund - and this will continue to apply to ISAs."

It may seem a surprise that most general PEPs incur lower charges than they would if you stuck your money into an investment without the extra administrative expense of a PEP wrapper.

"This is because of the long-term nature of PEP investor," says Ann Davis, a director at Fidelity. "They don't move in and out of their holdings as often as those who invest directly in unit trusts. This makes it cheaper for us, and we pass this on in lower PEP charges."

It is worth stressing that PEPs and their ISA successors are about long- term investment. PEPs, especially for higher rate taxpayers, allow investors to put their money away - for a recomended minimum of five years - in a tax-efficient shelter.

n Legal & General can be contacted on 0500 116622.

n Discount PEP brokers sell the full range of PEPs but pay back most of the commission that is built into PEPs. Leading firms include Allenbridge, 0800 339999; Chelsea Financial Services, 0171-351 6022; and Financial Discounts Direct, 0500 498 477.

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