It really does make sense for small investors who want to buy and hold shares (and not just stag new issues) to invest through a Personal Equity Plan. Dividends on shares held in a PEP are not liable to income tax, and any gains made on disposal are exempt from capital gains tax. PEPs make sense for small investors and they make even more sense for big investors, who are otherwise liable to higher rate tax on share dividends and who regularly expect to make capital gains in excess of their annual tax-free allowance.
PEP holders do not even need to declare the income or the gains on their tax forms. And unlike Tessas (Tax-Exempt Savings Accounts), which lose their tax-free status if the capital is withdrawn in the five-year life of the account, PEPs can be cashed at any time without losing the tax advantages they have already earned.
PEPs have been around since 1987, and anyone who bought the maximum amount allowed each year could have invested pounds 64,000 and with average luck should now be sitting on a tax-free portfolio worth at least pounds 100,000 and perhaps pounds 30,000 worth of tax-free dividends.
The annual investment limits have increased over the years - and the choice of investments has widened - so that anyone over 18 can now put up to pounds 6,000 during the tax year ending 5 April into a PEP which invests in a spread of shares, plus a further pounds 3,000 each year can be invested in the shares of a single company.
Since last July investors have been able to choose between a PEP invested in shares and a corporate bond PEP which invests in fixed-interest loan stocks issued by UK companies and the UK government gilts.
You do not have to invest the maximum sum to get a PEP, you can usually invest as little as pounds 500 as a lump sum, or put from pounds 20 a month into a regular savings PEP. You can buy a PEP off the page from an advertisement, you can buy one through a retail stockbroker, or get an independent financial adviser (IFA) to buy one for you. If you are in any doubt about where to start, both the Association of Unit Trusts (Autif) and the Association of Investment Trust Companies (Aitc) will be happy to send you a free fact sheet and a list of providers.
In practice, most PEPs are invested in a unit trust or an investment trust, which gives you a spread of investments, and you can monitor their performance from the prices listed in the main financial papers. You can choose a PEP which is intended to maximise dividend income, usually one with the words high income or extra income in its title; or you can choose one which is designed to produce capital gains, or one which tries to secure a happy medium; you can choose distribution PEPs which pay out the tax-free income or accumulation PEPs which reinvest the dividends.
These days you can also choose income shares in certain "split-level" investment trusts, which entitle you to the bulk of the dividends on the assets, while someone else gets the capital appreciation. Or you can choose tracker funds which select their investments to follow, almost exactly, the performance of a specific stock market index, usually the FT-SE 100 share index or the All-Share index. There are also a few "guaranteed" PEPs, like the Legal & General corporate bond, which deliver a fixed yield, and others which lock in capital gains.
Including corporate bond PEPs, there are now more than 2,000 different PEP plans you can choose from, almost as many as there are companies whose shares are listed on the stock market. But you can also use a self-select PEP as a way of investing directly in the stock market while still benefiting from the tax advantages of a PEP. You instruct a stockbroker which shares to buy and sell, and when to do so - but the shares are held in your PEP. More and more stockbrokers offer this service - and the cut-price share- dealing services will do it at their standard fee or less.
Which kind of PEP you choose depends on whether you want to maximise income or chase capital gains, or a combination of both. But you should remember that tax-free dividend income from a PEP benefits virtually all investors, while most investors are already exempt in practice from capital gains because they do not realise pounds 6,000 of gains anyway, and only the top 10 per cent or so will benefit from exemption. For most small investors therefore it makes sense to go for income from a PEP and go for gains outside the limits of a PEP plan.
It is estimated that around 14 per cent of the adult population now has a PEP, compared with the 16 per cent who have a Tessa. But while most investors are limited to a total holding of pounds 9,000, PEP investors can invest up to pounds 9,000 every year.
PEPs must invest directly in ordinary, preference or convertible preference shares in companies based in the UK, or the European Union provided they are listed on a recognised stock market, or in corporate bonds or convertible loan stock of UK companies which are priced in sterling, pay fixed rates of interest and have at least five years left before they mature.
That includes Eurosterling bonds issued by UK companies offshore, but excludes bonds issued by companies in the financial sector such as banks. But PEPs can be invested in unit trusts or investment trusts which invest at least half their funds in qualifying assets.
As a further dispensation investors can get some exposure to the US, Japan or emerging markets by putting up to pounds 1,500 out of their pounds 6,000 allowance into unit trusts or investment trusts which do not qualify - provided that any further investment in the same year is managed by the same provider.
You can only buy one PEP (or one equity PEP plus one bond PEP) each year, but you can buy from a different provider each year, and you can transfer your PEPs to another manager each year. But you cannot simply set up your own PEP. You have to go to a bank, building society, stockbroker or one of the new providers such as Virgin or Marks & Spencer.
Investors must remember that PEPs, like shares can fall as well as rise, and providers can deduct initial charges, exit charges and annual management charges, which have to be set against your tax-free advantages. but even these are falling as a result of competition.
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