The tax-free way to wrap up your cash

WHEN Nigel Lawson, then the Chancellor, introduced personal equity plans (PEPs) in his 1986 Budget, he could hardly have imagined he was spawning a pounds 35bn industry, which costs the Government pounds 180m in lost tax every year.

But today many PEP-holders do not understand just what it is they are buying. The PEP itself is not an investment plan, merely the wrapping that allows you to shelter unit trusts or other investments from tax. All investment returns are free of income and capital gains taxes.

Bizarrely, it can often be cheaper to buy a unit trust in PEP form than stand-alone. For example, Morgan Grenfell's PEP, which offers a choice of eight Grenfell unit trusts, takes just 3 per cent of your money at the outset as a charge deduction, compared with up to 5 per cent if you buy the unit trusts without the PEP wrapper. In the case of unit trusts then, but not other types of PEPs, the wrapper is free. Ian Millward, of Chase de Vere, the independent PEPs adviser, says: "With a unit trust- based PEP, you're not paying more and you're often paying less to be in the PEP, so you might as well take it anyway. Besides, who knows what will happen to tax regimes under a Labour government?"

You can put up to pounds 6,000 into one PEP each tax year, making both the income and the capital gains from that money tax-free. Another pounds 3,000 a year can go into a separate single-company PEP, but these are limited to individual shares, not unit trusts.

You can choose from more than 300 unit trust PEPs. Some will put your money into a single unit trust, others let you mix and match from a range of funds of one company.

Not all unit trusts qualify for full PEP status. Qualifying trusts must hold 50 per cent or more of their assets in the UK and other European Union countries. Only pounds 1,500 a year of your pounds 6,000 investment can be devoted to trusts investing outside the EU.

Most investors will have no problem with this. But if you feel strongly that the best stock market growth over the next few years will come from, say, America or the Far East, then you may be willing to sacrifice the attraction of tax-free returns from a PEP in the hope of getting higher returns elsewhere.

For many people, the capital gains tax exemption offered by a PEP will be irrelevant, at least for the plan's early years. Brian Tora, a director of stockbroker Greig Middleton, says: "The basic benefit of the PEP is that you save on income tax. If you are a standard rate taxpayer putting pounds 6,000 into a PEP, you might reasonably expect that pounds 6,000 to produce pounds 240 of income a year, that's 4 per cent. The tax you're saving is pounds 60 a year."

But the CGT exemption is very relevant for larger investors, who may have already used up their pounds 6,000 annual CGT exemption elsewhere. Mr Tora says: "The reality is that PEPs favour the well-off. If you can afford to put pounds 9,000 a year into your PEPs [both pounds 6,000 and pounds 3,000 PEPs], and not many people can, then by now a husband and wife could have built up pounds 150,000 in a tax-free fund."

Chase de Vere estimates that an investment of pounds 6,000 in a PEP every year for 25 years could produce a final return as high as pounds 500,000. That means many mortgage lenders are now prepared to accept PEPs as a viable mortgage repayment vehicle. Borrowers pay only monthly interest on the loan, relying on tax-free growth from the PEPs to repay the capital sum.

However, Chase de Vere warns that because of the volatility of any stock market investment borrowers should consider switching to a safer vehicle as the final repayment date nears.