Tax Planning: No need to mourn for Tessa

With interest rates firmly on a downward curve, it becomes especially important to protect what little growth there is from the Inland Revenue.

For almost a decade, the main way to keep all the interest you earn on savings has been the Tessa, or tax-exempt special savings account. Tessas reward savers with generous, tax-free interest. The scheme's rules are widely regarded as inflexible and Tessas will be replaced this April by the cash element of the individual savings account (ISA).

The main drawback of Tessas is their five-year term. Although it is possible to withdraw money before then, doing so removes the account's tax-free status. The only exception is net interest, which savers can withdraw without penalty.

"The main difference between the Tessa and the ISA is access," explains John Warburton, investment product manager at Halifax Financial Services.

"One of the main impediments to people saving with Tessas was the perception that any savings were tied up for five years. With ISAs, savers can take their money out without penalties."

Anyone who does not already have a Tessa can open an account and deposit up to pounds 3,000 between now and April. Skipton BS is paying 7.4 per cent interest on its Tessa but you have to pay in the full pounds 3,000. The Portman is paying 7 per cent on pounds 1,000 upwards by post and pounds 100 if you live near a Portman branch (mainly in the South and South-east).

Tessas are independent of any other tax-free investments, such as PEPs, so a Tessa could be a valuable option for someone who has already used up his or her other allowances. Higher-rate tax payers will benefit most of all.

From April, cash-based ISAs will play much the same role as Tessas do now. However, there will be some important differences. ISAs are multi- purpose accounts that can hold cash, investments such as unit trusts or shares, or insurance policies.

ISAs should be more flexible, as there is no standard fixed term. Banks and building societies will be able to offer both notice and instant-access accounts under the cash ISA rules, but this is likely to be at the expense of lower interest rates. One reason Tessa interest rates are attractive is that they are long-term savings accounts.

"There is no specified minimum holding, but we can't expect to see the same interest rates on ISAs as we do on Tessas," suggests Paul Freeman, senior manager, personal financial planning, at accountants PricewaterhouseCoopers.

"Tessas pay well because the money is tied up for five years. With ISAs, the rate will depend on how long you are prepared to tie up your money," Mr Freeman added.

Some banks and building societies have already announced the opening rates for their ISA accounts. Abbey National, for example, will pay 6 per cent on amounts up to pounds 999 and the bank will not drop rates below base rate until July 2000. In the first year, savers can put pounds 3,000 in cash into an ISA. From 2000, the limit falls to pounds 1,000. Savers whose Tessas mature will be able to put the capital into a new, Tessa-only ISA; this does not need to be with their existing Tessa provider. The Tessa-only ISA is a separate, tax-free savings account and does not affect the other ISA allowances. This means that savers who want to maximise their tax- free cash and who are able to tie up their money, can boost their holdings by taking out or topping up a Tessa now and converting it to a Tessa ISA when the five-year term finishes.

The main alternative tax-free savings products come from National Savings. National Savings certificates are sold either with fixed interest or index- linked, with a fixed margin over inflation: currently, the rate is inflation plus 1.65 per cent. National Savings is an extremely safe home for money and for higher-rate tax payers the tax-exempt status of investment certificates can look particularly attractive. The disadvantage is that the certificates are sold for a fixed period and the interest is added to the capital, so they are not suitable for savers looking for an income.

Savers who are willing to speculate but still protect their capital do have some other options. One is to put the money into a building society in the hope that it will convert to a bank and distribute windfall shares. The windfall goldrush may well be over, though, with only a few large societies still mutual. Many building societies have placed restrictions on windfall payments. For savers who already have money in a mutual building society, or who can find one that allows them to open an account, there is a large incentive as windfall benefits are tax free.

Winnings from Premium Bonds and the National Lottery are tax free, too, but the lottery at least hardly qualifies as a safe investment.

"Premium Bonds are quite interesting," suggests Paul Freeman at PricewaterhouseCoopers. "You do get your stake back and the winnings are tax free. Provided you are prepared to take a risk, there is a chance of a good tax-free return."

n National Savings can be reached on the internet at www.nationalsavings.org.uk or 0645 645 000. Portman BS: 0800 807080; Skipton BS: 0800 446776.

n Information on ISAs is available from Chase De Vere on 0800 985 9000.