Money: grand bonus for with-profits funds

THE CELEBRATIONS which followed the Chancellor's decision to allow all PEPs to retain their tax advantages after the introduction of Individual Savings Accounts (ISAs) next year obscured the news that we will also be able to put pounds 1,000-worth of life insurance funds into the new tax-free ISAs.

The final details won't be published until next month, but it seems certain the new scheme will offer cautious investors a chance to get better performance from with-profits funds.

The big life insurance firms and friendly societies run giant with-profits funds. They are made up of a mix of shares, gilts, property and other investments. Profits, as the name suggest, are added to the value of investors' policies in the form of annual and final bonuses. This smooths out the effects of stock market fluctuations and the life company can't take away what's already been added as a bonus. If you have an endowment policy with your mortgage, it too is likely to be invested in a with-profits fund.

The new rules signal a big change in the way with-profits funds are taxed. At the moment, basic-rate taxpayers with life company endowments and with- profit bonds don't have to pay any extra tax on the proceeds as the fund itself is taxed. From 1999 onwards, insurers will be exempt from tax on any income or gains they make within the fund. Until 2004 they'll also benefit from a 10 per cent tax credit paid on share dividends. At least some of this extra cash should be passed on to investors.

The new ISA rules are especially good news for higher-rate taxpayers. At the moment they have to pay income tax on part of the payouts from some with-profits investments, such as single premium bonds. But anything you put into an ISA will be totally tax-free.

The new ISA rules have, however, been worded to make it clear that eligible life policies will be of the "single premium" type. Peter Telford, head of life products at Legal & General, says the insistence on only "single premium" products being included in ISAs is probably a response to insurers making high charges on policies with monthly premiums, such as endowments. He says: "Single premium policies have more explicit charges - what you see is what you get."

Despite this, it seems likely that friendly societies and life firms will set up monthly payment schemes to spread the cost for smaller investors.

It should be possible to do this without breaking the rule that a policy should strictly be called a "single premium" scheme. If not, of course, it makes a nonsense of the plans to make ISAs a way to open savings schemes up to people on modest incomes.

The small print on the new life insurance ISA scheme won't be finalised until May. Until then the Inland Revenue can't confirm whether we'll be able to convert existing policies to ISA schemes, or whether the tax breaks will only be available to new investors in specially designed ISA policies.

Some experts believe ISAs will be open to a wide range of products already sold by life insurers. Rebekah Kearey, an indepen-dent financial adviser in Brighton, says: "I'm expecting new endowment policies to be included in ISAs. I wouldn't mind betting that the Government will use it to get rid of the remnants of Miras, which is now worth just 10 per cent on the interest on the first pounds 30,000 you borrow." Ms Kearey hopes ISAs will give a boost to endowments.

It seems the pounds l,000 annual ISA allowance for life insurance policies was originally included in the plans to keep friendly societies happy. They offer 10-year policies combining investment with life insurance. There's a pounds 270 annual limit on investment, and final payouts are tax-free. As friendly societies appeal to those with a small amount to invest, they are perfect for ISAs which are designed to encourage more people to save money.

Although friendly society policies already make tax-free payouts, it will be worth putting them in an ISA because their with-profits funds will benefit from the same tax breaks given to big life insurers.

Most experts believe the Government intends us to put investment-linked life policies in the ISAs, rather than simple life insurance.

However, Kent-based IFA Brian Dennehy believes there are instances where straight life insurance could go into an ISA. For example, he feels the tax breaks offered to people who take out term assurance linked to personal pensions may only be offered when the insurance is put into an ISA.

Peter Telford at L&G says there is scope for firms to design new products which could combine a life insurance element with investment. This is what an endowment or friendly society bond already offers.

Don't hold your breath for big innovations from the life companies, but there's no doubt that with-profits funds will be more attractive in future. It may be worth using your pounds l,000 annual allowance to make some steady, tax-free gains.