Tax-Exempt Special Savings Accounts: Strict but simple rules keep your savings sweet

The rules governing tax-exempt savings accounts, or Tessas, can be summed up as strict but simple. Keep to the rules and the interest your money earns is entirely tax free. Break them, and the taxman wants his share.

Fortunately, most of the rule-following is normally done by the financial institution that operates your account. So if, for example, you try to deposit more than the maximum allowed, the excess will be rejected. However, the differences between the rules on Tessas and those governing personal equity plans, or PEPs, need to be properly appreciated.

First, new PEPs can be started every year. But you can only have one Tessa and you have to be over 18. With Tessas, husbands and wives can each have one, but you can not open one for your children or grandchildren. The account has a five-year term; withdraw your capital earlier, and your interest will be taxed as in other savings accounts. You can withdraw the net interest, though, without losing the tax break.

There are strict limits to the amount you can invest in your Tessa. If it is your first Tessa, you can deposit pounds 3,000 in year one and then up to pounds 1,800 in each of the following four years, to a total of pounds 9,000.

At the end of the five-year term you can open a follow-up Tessa and pay in all the capital, but not the interest, from your first. If that is the full pounds 9,000 you can not make any further deposits until the end of the second five-year term. However, if the total deposits (excluding the interest) in your first Tessa come to less than pounds 3,000 you can top up a second Tessa to this pounds 3,000 level in the first year.

To allow time for financial planning, the rules allow up to six months between the date your first Tessa matures and the start of a second Tessa.This allows you to roll over the full pounds 9,000. Although you cannot touch the capital during the life of a Tessa without forfeiting the tax-free status, you can take some of the interest - limited to the amount you would have earned if the account had been an ordinary taxable type.

If, say, you have pounds 1,000 in your Tessa and the interest rate is 5 per cent, you will earn pounds 50 interest, credited to your account. On an ordinary savings account, pounds 12 of this would be taken in tax - 24 per cent of pounds 50 - leaving you with pounds 38. But since this is a tax-exempt account, no money is handed over to the Exchequer. Instead, you can draw the pounds 38, retaining the pounds 12 in the account until the five years is up.

These are Inland Revenue rules, but individual operators may have their own for interest payments - one more reason to carefully check the small print.