Don't let taxing choices lead to a bad mistake

WHEN YOU have money to invest, there are always plenty of people dying to take a bite out of it. Fund managers make their charges and intermediaries take commission. But the biggest chunk goes into the taxman - unless you can avoid it.

Successive governments have devised a whole host of tax-efficient or tax-exempt ways to invest, from Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (Tessas), to pensions, National Savings and insurance- linked products. But are they always a good buy simply because they are tax-free?

While a tax-efficient investment will give you a higher net return than the same investment with no tax break, advisers warn against choosing a particular investment product on its tax status alone. "There are circumstances where you'd be wise to go down the tax- exempt route, but not always," says Dawn Slater of independent financial advisers Dawn Slater Associates.

The most important consideration is that the investment is suitable for you and offers the prospect of good returns. For instance, personal pension plans allow you to save for retirement out of your gross income, with the investment growing tax-free, plus the prospect of a tax-free lump sum on retirement. For someone with no access to an occupational pension scheme, personal pensions normally make sense. But if you are not able to tie money up until retirement, then they are not the right choice.

PEPs allow investors to hold share-based investments and some types of bonds without any liability for income tax on the dividends or capital gains tax on the profits.

With PEPs, it is not just the tax-break that boosts returns. Some providers have lower charges on their PEPs than they do on the same investment without the tax-free wrapper. This is because of strong competition in the PEP market.

However, it is still vital to choose a PEP provider or fund management group that you judge to have good performance prospects and reasonable charges.

In any case, owning shares may mean taking on more risk than you feel comfortable with. A lot of money which would otherwise be saved in a building society account has gone into PEPs, although many savers do not understand the risk of owning shares, says Stephen Dight of IFAs Grosvenor Financial Services. "You shouldn't necessarily change your investment strategy just to get your tax allowances," he says.

"As long as you wanted to make that investment anyway a PEP could be a good idea," he says. "But a lot of people have taken them out for all the wrong reasons."

Many investments look attractive in their marketing literature because they are tax-free, but they would be very unattractive without that status. Friendly societies offer regular savings plans that give a tax-free return. The plan has to be kept going for 10 years to get the full benefits, and the most you can invest is pounds 25 a month or pounds 270 a year..

"Some of these friendly society savings plans offer poor value, but on the other hand, they're accessible at pounds 10 a month," says Ms Slater. People on lower incomes could not afford the level of monthly contribution demanded by many PEP/ISA providers; friendly society plans plug that gap.

Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EIS) offer tax breaks, although they can be risky. The EIS was intended to help companies to raise small amounts of equity finance.

Investors in an EIS company get 20 per cent income tax relief on their investment, and all the gains on those shares are free of capital gains tax.

Venture Capital Trusts are similar to investment trusts, but mostly invest in unquoted companies or shares listed on the Alternative Investment Market. They are generally less risky than an EIS, says Stephen Dight. "You have to draw the line somewhere. These focus on the tax break and not the investment. You are better off playing safe with your net income than gambling with your gross income and losing the lot," says Mr Dight.

Grosvenor Financial Services, 01491 414145; Dawn Slater Associates, 01635 45325

Independent Guides

The Independent has published three guides to investing your money. The first is a `Guide to PEPs', which details exactly how PEPs work, what their tax effect is and which ones might suit your needs. The guide, sponsored by Scottish Widows, is available by calling 0345 678910

The second is a `Guide to With-Profits Bonds', aimed at those savers who might prefer a rather safer home for their investment. This guide, sponsored by the With-Profits Bond Shop, is available by calling 0845 2711007

The third is the `Guide to High Risk/High Reward Investment', which explains how to achieve greater investment gains - at the cost of accepting higher risk to your money. This guide, sponsored by Whitechurch Securities, is available by calling 0845 271103