Tax-Free Saving: Can you take the money and run?

LESTER PIGGOTT, the jockey, got into hot water with the Inland Revenue when he tried to pay no tax on his income. You can avoid the same troubles by using savings opportunities that allow you to receive income on your cash tax free.

Your choice extends from personal equity plans and Tessas to the government- backed National Savings. The former two are under notice, as they are due to be replaced by the Individual Savings Account in April 1999. But you still have useful opportunities to use the different benefits that both offer.

PEPs are a way of sheltering investments from the Inland Revenue. Dividends on shares held in PEPs, in effect the income, are paid tax free. Additionally, any gain made through a rise in share price is exempt from capital gains tax.

However, buying shares to gain a tax-free income is a dubious and highly risky strategy. Most investors spread the risk of investment by choosing unit trusts or investment trusts that invest in a number of other companies. Because the underlying investments are diverse, you are less likely to be hit by a sharp fall in any one individual share.

But getting income through one of these managed funds can prove difficult. The basic problem is that if you make regular withdrawals from a fund to provide the income you require, you could be eating into your capital. There are specially designed income funds which you can put in a PEP but the income requirement can prove to be a major drawback, according to Geoff Rollin, director at Devonshire Wilson Financial Services, a member of the Financial Options Group. "Income funds have a specific risk in that the fund deducts its annual charges from the capital," he says. "This means that the income is higher than would have otherwise been the case, so growth in the capital can be constrained."

Despite the drawbacks, income funds remain popular with investors, particularly the elderly who need to raise an income from their investments. "But investors need to make a number of decisions when choosing the right funds," says Graham Bates, an independent financial adviser with Bates and Partners in Leeds.

"The key is to look at the unit trust sector that is most likely to meet your investment objectives," he suggests.

"For example, funds in the UK Equity Income sector will give you a low starting yield but the best prospect of long-term capital growth. Funds in the UK Equity and Bond sector offer a slightly lower risk and a higher initial yield, but less potential for growth. Those needing the highest level of income should look at the UK Fixed Interest sector, where the funds offer high initial income but limited growth potential."

When considering any investment in PEPs, it is important to bear in mind the level of charges that could have a dramatic effect on the value of your capital.

This is even more true when considering corporate bond PEPs. Corporate bonds are fixed-interest bonds issued by companies to raise money. The companies pay interest on their bonds and repay the capital at a pre-set date. Investors are therefore lending a company money for a fixed time and receiving interest on the loan until it is paid back. Convertibles, also allowed in a corporate bond PEP, are similar in that they offer a fixed rate of interest, but they also offer investors the chance to convert their option into shares. For that reason they offer lower returns than corporate bonds, but do offer the extra potential of enjoying the capital growth associated with equities.

Corporate bonds pay yields, in effect income, and the returns can be much greater than equity yields. You could expect around 7 to 8 per cent with corporate bonds compared with 3 to 4 per cent with equities.

Returns of up to around 8 per cent are currently on offer from tax-effective Tessas. However, to keep the tax benefits offered by Tessas you must be careful about any income you draw. The simple fact is that any withdrawals from a Tessa means forgoing the tax advantages. But you are allowed to take out the interest earned on your money.

A handful of Tessas have been designed to pay out an income to investors on a monthly basis. Among those banks and building societies offering a monthly income option on first Tessas are Alliance & Leicester, Co-Operative Bank, Investec Bank (UK) and Scottish Building Society.

National Savings also offers tax-free savings opportunities. There are two types of Savings Certificates - fixed interest and index-linked, which allow you to inflation-proof your savings. Both are five-year investments and pay a tax-free guaranteed rate of interest. Investors have to keep the certificates for the full five years to receive the tax-free income.

If a certificate is encashed in year one, you will receive no interest. And unless you keep the certificate to maturity, you will receive a reduced amount.