Your Money: Blinded by the spectre of Hector

We are about to enter a new season. The run-up to the end of the tax year is always a good time for financial advisers and 1998 will be exceptional, following the Government's decision to hand them a large carrot with which to encourage us to invest in tax-efficient schemes, 'while stocks last'. However, as John Andrew warns, it pays not to be too swayed by the 'tax-free' mantra.

In December the Government announced its proposals for a new instant- access, tax-free savings account. Called the Individual Savings Account (ISA), it will be launched in April 1999. Personal Equity Plans (PEPs) will then lose their tax-free status and Tax Exempt Savings Accounts (Tessas) will be withdrawn, though existing ones will be allowed to run their course tax-free.

Up to pounds 5,000 each year, of which no more than pounds 1,000 may be in cash and pounds 1,000 in life insurance, subject to an overall limit of pounds 50,000, may then be invested in an ISA. However, existing PEPs and maturing Tessas can be immediately transferred to the new ISA, subject to the proposed pounds 50,000 limit. The final details of the new ISA will be announced by the Chancellor of the Exchequer, Gordon Brown, in his Budget speech next month.

Meanwhile, anyone who has not taken advantage of the existing tax-free vehicles, or has less than pounds 50,000 invested in them, should consider making maximum use of both now. Each adult UK resident may invest up to pounds 9,000 in PEPs in any one tax year. Every individual may have one Tessa, which is a five-year savings plan. Up to pounds 3,000 may be invested in the first year and up to pounds 1,800 in each subsequent tax year, subject to an overall limit of pounds 9,000. Taking advantage of the available tax-efficient opportunities now will help towards maximising the opportunities to be offered by ISAs.

Naturally it is good to have your own personal tax haven out of the clutches of the Inland Revenue. However, there is a danger of concentrating purely on the tax-free nature of PEPs and Tessas and ignoring the fundamentals.

It is important to realise that both are medium- to long-term commitments. PEPs are stock-market investments that carry varying degrees of risk. Ideally any investment in stocks and shares should be viewed as at least a five-year commitment.

If you are normally risk-averse, or do not have funds to tie up for a long period, then the stock market is not for you. The fact that PEPs are tax-free does not alter your acceptance of risk or the period of the investment. Even if you do not fall into this category, it is important to check that PEP charges do not outweigh the tax advantages.

Although a Tessa is no riskier than a normal savings account, it must be remembered that it is only tax-free if it runs for its full term. Take any of the capital from the account and the tax-free status is lost. The retained "tax" element remains in the Tessa and earns interest until the end of the term.

When a Tessa is closed early, the total pre-tax interest to date is treated as income in the year of closure. While normally this will not be a problem, the danger is when the boost in income moves the saver into a higher tax bracket. This factor should be considered by savers who are not sure if they will be able to stay the course and whose income is near the upper limit for their tax bracket.

We all know that it is prudent to make adequate provision for our retirement. However, again it is important not to let the tax efficiency of pension plans blur your judgement. It is vital to remember that sums paid into a tax plan are irrecoverable. True, at retirement up to 25 per cent may be taken as a tax-free lump sum, but traditionally, the rest normally has to be used to purchase an annuity which provides an income.

This is fine, as long as there is not an over-commitment. You cannot ask the pension plan provider to return part of your contributions because you want to replace the car. There has to be a balance between providing for your retirement and having sufficient capital for your short- term requirements, regardless of the tax efficiency of pension plans.

Since last July, the Inland Revenue has been carrying out a wide-ranging review of tax avoidance. The Labour Party is known to dislike the current Potentially Exempt Transfer (PET) regime, under which no tax is payable on most lifetime gifts if the donor survives for seven years after making the gift. Possible changes may involve complete abolition, with tax being paid as soon as the gift is made, or extending the seven-year period.

While it appears unlikely that any future changes would be retrospective, one cannot be sure until the details are announced. Indeed, with ISAs, the Government's proposals on the amount of funds that previously held PEPs which can be transferred into the new vehicle indicates that retrospective taxation is not something that worries the Chancellor. The changes are likely to have a significant impact on the current range of techniques currently used in Inheritance Tax (IHT) planning.

Obviously anyone contemplating reducing their estate's liability to IHT should act sooner rather than later. However, it is important that tax advantages should not outweigh more fundamental considerations. It does not make sense to take action which will leave the donor short of funds, and it is infuriating if a large proportion of the funds are lost to the family when the recipient divorces his or her partner.

Be tax efficient by all means, but do not let the saving of tax distort your vision.