Tessas: should you stay ...

TESSAs are probably the best tax-efficient savings option for investors worried by the thought of losing their money.

Tessas were John Major's contribution to the savings scene during his brief stint as Chancellor of the Exchequer. His aim was to encourage people to save for the medium term by developing a vehicle that was safer than a standard equity investment and had better returns than a building society savings account.

The idea has worked. Since their launch in 1991, Tessas have attracted about pounds 25bn.

They are designed to encourage people to save by offering tax-free interest. Savers can put up to pounds 9,000 in a Tessa over five years, but they are restricted to pounds 3,000 in the first year, followed by up to pounds 1,800 in each of the second, third and fourth years. In the final year, investors can top up the fund to the pounds 9,000 limit.

To benefit from the full tax advantage, annual interest income should be left in the account until the end of the fifth year, when the account matures and the entire proceeds can be taken tax-free. Savers can withdraw the equivalent net interest during the five-year savings term without loss of tax privileges, but the tax-free element has to be left alone until maturity. Otherwise, the Tessa is closed and all the interest is taxable.

Some Tessas offer fixed rates for the full five-year term. Others have variable rates, while a growing number pay returns that are linked in some way to the performance of the stock market.

Anyone who made the maximum pounds 9,000 investment in the best of the Tessas maturing currently will have seen their money grow to more than pounds 12,000. But the difference between the best and worst is considerable. A pounds 9,000 investment in the top-performing variable-rate Tessa, from Kent Reliance building society, could be worth pounds 12,400 on maturity, according to Moneyfacts. This is nearly pounds 1,000 more than Clydesdale Bank's Tessa, where a pounds 9,000 investment could be worth little more than pounds 11,400 on maturity.

With the first batch of Tessas maturing this month, savers must now decide what to do with their money. You can roll over all the capital you put into your first Tessa - up to pounds 9,000 - into a new Tessa, but not the interest earned.

To take advantage of this pounds 9,000 rollover concession, you must open the new Tessa within six months of the old one maturing. And the overall ceiling of pounds 9,000 on a Tessa will still apply, so anyone putting in the full amount in the first year will not be able to invest more over the next five years. If you miss that six-month deadline or are a first-time Tessa saver, the first-year investment limit is just pounds 3,000.

Anyone who plans to invest in Tessa Mark II should shop around before deciding whether to remain with the same bank or building society. While your existing institution could be offering a special deal if you roll over your existing Tessa capital, you may well be able to do better elsewhere.

Investors can switch between different institutions without forfeiting the tax-free status of their Tessa money. If you think you might want to switch Tessas in the future - which you can do during the five-year savings period, say from a variable rate to a fixed - it is important to look for a Tessa that carries no or lower penalties for such transfers.

But perhaps the biggest question for anyone considering a new Tessa is whether it is sensible to lock up your money in a savings account at all for the next five years. With interest rates so low at the moment, some investors may want to gamble on the stock market, using a tax-efficient personal equity plan.