Tax Free Savings: Investment still a saving grace

As tax benefits on savings shrink, beware of the tax-free tag for its own sake.

SAVING and investing with help from the tax system may sound great. But most plans which were tax free under the last government now offer only shrunken tax benefits under this one - and they are due to shrink further. If you still have an existing Personal Equity Plan or are saving via a Tessa, you are doing far better then you would with an ISA - an Individual Savings Account. Admittedly pensions still offer big tax concessions. But even they are not what they were.

ISAs are the best available choice on flexible savings. Managers can still get 10 per cent tax relief on dividends coming into their funds, boosting your eventual returns. That is only half what you could claim on PEPS and the concession will come "under review" in three years time - probably a euphemism for killing it off. But gains from rising share prices will probably still remain free of capital gains tax. But last year less than one in every 200 people faced a bill.

At least cash ISAs pay their interest tax free so in tax terms, they are a better bet. But that only shows the folly of taking only tax into account, when historically investment has almost always offered better returns than savings in the long term.

Overall, the tax benefits ISAs offer are shrinking - and so are the sums to which they apply. The limits on how much you can save are already only half those which applied to PEPS and Tessas combined. Many people had both. The tax help is due to drop further in April, with the new financial year. Details appear in the article on ISAs below.

Venture Capital Trusts offer far more - but do not make sense unless you have endless assets and enjoy taking risks. The trusts invest in a range of unquoted companies, and lock in your money for five years. You get full tax relief on what you invest, and some capital gains tax advantages. Those tax benefits may be useful but are no reason for investing if the schemes do not match your risk profile.

Pensions still get plenty of help from the tax system. You can set all your contributions against tax, so that they come at a 23 per cent or 40 per cent discount depending on the tax rate you pay. There are limits on how much you can contribute, whose size depends on your age, though very few people come anywhere near paying them.

One of Gordon Brown's "stealth taxes" cuts back the benefits when money is inside a pension fund. Managers can now collect only 10 per cent tax relief on the dividends they earn, half the old rate. That concession is also up for review in five years.

At least one concession remains. You can take up to a quarter of the pension money you have saved at retirement tax free. The rest has to buy you an income for life.

National Savings, with tax-free National Savings Certificates, aims at a more short-term market. You can choose the two-year certificates, where rates are slightly lower than for a five-year version. Both offer fixed rates, but when interest rates are set to rise, two-year flexibility looks to be a better bet.

Whichever you choose, the proceeds are tax free. Even so, the figures do not look that good. Assuming that you go for the five-year certificate, you will collect a basic 4.3 per cent tax. If you gross that up, it is worth 5.38 per cent if you pay basic rate tax, and still below 7.2 per cent on the higher rate.

Tax-free terms are not worth taking simply because they are tax-free. Savers with ready money can get an admittedly taxable 6 per cent in an Egg account, though you have to use the Internet. Anyone wanting good fixed- rate National Savings terms should consider investing, after Thursday's .25 rate increase to 5.5 per cent, when the Government has a new issue.

The National Savings Bank ordinary account may offer tax benefits - but has nothing else to recommend it. It combines the worst features of savings and cheque accounts elsewhere, with no cheque book and very little interest. It pays one cent on anything under pounds 500 - which is hardly going to make anyone rich, even if the first pounds 70 of interest is tax free. The average balance is around pounds 70.

The proceeds of premiums bonds are tax free, admittedly. But they lack the sex appeal of the Lottery, with only one pounds 1m prize a month.

The Treasury does not like tax reliefs. The more successful they are in making people save or invest, the more potential tax revenue goes missing. In the past, you could get tax relief on mortgage payments in full, though that has now all but disappeared. There used to be smaller benefits on taking out life insurance policies, but those are now consigned to history too.

Tax benefits on ISAs are due to shrink - and the National Savings contracts are not particularly attractive anyway. In the past, tax reliefs could beautify products quite successfully. Now, most do no more than add a touch of fiscal lipstick.