Tax-efficient investments: There's no free lunch

No one likes paying tax. And when the Inland Revenue takes a hefty chunk out of your investment returns, it can be demoralising. So any investment which can claim to be tax-efficient, or better still tax-free, has instant appeal.

In the state's attempts to influence the public's saving patterns, a host of tax-free investments have been pushed our way. These include Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (Tessas) - soon to be replaced by Individual Savings Accounts (ISAs) - and a variety of pension plans.

No one should invest in something purely because of its tax status. Just because an investment sports the "tax-free" label, does not mean it is necessarily a good choice.

"But it's silly not to take up your entitlements of those (PEPs, Tessas) if you would have chosen those investments anyway," says Peter Smith of independent financial advisers Hill Martin.

PEPs have been a huge success story since they were launched in 1991. Investors have built up impressive equities portfolios by steady monthly contributions coupled with the tax-free benefit.

"For investments such as PEPs, going into a unit trust directly when you haven't used your PEP allowance does not make sense," says Kevin Minter, financial planning manager at independent financial advisers, the David Aaron Partnership. If a couple had invested pounds 12,000 in the Gartmore UK Index unit trust five years ago without using the PEP wrapper, that investment would now be worth a net pounds 22,655. If they has used their PEP allowance, the same investment would be worth pounds 23,570.

However, in some cases the difference could be even more pronounced. A few providers actually have lower charges on PEPs than they do on the underlying unit trust. Fierce competition in the PEP market is part of the reason for this. Fund managers are also keen to attract PEP funds, because these do not tend to move as much as money invested in standard unit trusts, says Peter Smith.

Sometimes certain tax- saving investments are not a particularly bright idea. "Tax- efficiency is a cornerstone of financial planning, but you do need to be looking at the actual returns you are getting," says Mr Minter. Tessas pay tax- free returns on cash deposits - subject to rules. "With interest rates falling over the next five years, even with the gross return, it might not be very attractive. Anyone taking out a Tessa now might end up with between 5 and 6 per cent gross interest on average. But if you want to lock your money away for five years, there may be better places to lodge it."

Single-company PEPs can also work out more expensive than holding the same shares outside the tax-free wrapper. "For the basic-rate taxpayer, there are a lot of single company PEPs where the management charge can be equal to or greater than the tax savings," says Mr Minter.

Last year, the yield on the FTSE - the average dividend paid by the country's 100 biggest companies - was about 3 per cent . So the tax saving afforded by the PEP shelter would be 0.6 per cent. However, charges levied on a single company PEP can be 1 per cent or 0.75 per cent.

Although the PEP holder would also be exempt from paying tax on any capital gain made on the investment, this may be no advantage. Each person has an annual capital gains tax allowance of pounds 6,800 anyway.

Personal Pension Plans are long-term investments and can keep huge amounts of money from falling into the hands of the Inland Revenue. For someone who has no access to an occupational pension scheme, personal pensions do normally make sense as a way of building up a retirement income. But many pensions currently available are poor because of their charges, or because they are too complicated to understand.

Also, money invested is locked away until at least the age of 50. "If you're young, there's a big postponement going on," says Peter Smith. This is why there is a need for other types of investment to save for retirement, he says.

PEPs, Tessas and National Savings are not the only tax-free investment opportunities. For more sophisticated investors, Venture Capital Trusts and Enterprise Investment Schemes (EIS) offer tax breaks - but the risk is high.

Venture Capital Trusts are similar to investment trusts, but mostly invest in unquoted companies or shares listed on the Alternative Investment Market. The EIS is a scheme to help companies raise equity finance. Anyone investing in an EIS company gets 20 per cent tax relief on the investment - and this is just one of the tax breaks.

When it comes to selling the investment, there can be problems since there is often no secondary market, as the pur- chaser will not get tax relief.

Anyone investing in an EIS or VCT should first ask themselves how happy they would be with that investment if no tax relief were available.

Hill Martin, 0171 233 2777; David Aaron Partnership, 01908 281544