In search of a sound safe haven

Just because a scheme is tax-efficient does not make it efficient at making money. Here and on pages 14 to 18, we survey the multitude of investment vehicles and their virtues and pitfalls

FROM PEPs to pensions, Tessas to trusts, the Government has created many schemes to encourage various sorts of savings and investment.

Making sense of it all can be bewildering at first; this is an area infested with acronyms. PEPs are personal equity plans, the main tax-free route to investing in shares. Tessas (tax-exempt special savings accounts) are the equivalent for savings in bank and building society accounts.

This Independent on Sunday special report will help you find the investment plan best suited to your financial needs. First, though, a word of warning - you should never make an investment purely to save tax. It is better to have a taxed investment that makes money than a tax-efficient scheme that loses money. A good example is the now-defunct Business Expansion Scheme, originally intended to encourage investment in small businesses but which financial advisers exploited to offer generous breaks to higher- rate taxpayers investing in rented property. However, many of the early BES investments in trading companies lost their investors' money, or made them only negligible gains.

Here are the main tax-free options:

o National Savings certificates. One of the simplest and safest forms of tax-free investments.they are government-backed and you can buy them at post offices with as little as pounds 100.

Investors worried about inflation should look at index-linked certificates. To receive the best returns, savers must hold their certificates for five years, when they will earn interest of 3 per cent a year compound in excess of the retail price index.

Anyone looking for certainty about the level of their returns may prefer National Savings' 42nd issue of fixed-interest certificates. These pay up to 5.85 per cent a year compound, worth almost 8 per cent to a basic- rate taxpayer. Again, savers must hold on for five years to receive the full 5.85 per cent.

o Tessas. Most savers will be more attracted by the higher returns on offer from Tessas in the first instance. Currently these are paying up to about 7.5 per cent fixed or, on Tessas where the rate can change along with savings rates generally, up to around 7 per cent. Interest on your Tessa savings will not be taxed as long as you do not withdraw any of the capital for five years.

Savers may invest up to pounds 9,000 in a Tessa - pounds 3,000 in the first year, and up to pounds 1,800 in each of the remaining four years. Anyone with an existing Tessa can roll over up to pounds 9,000 into a follow-on account

Tessas were introduced in 1991 and nearly two-thirds of the first generation will mature in the next six months. Banks and building societies are making special offers to try to hang on to and poach the pounds 15bn or more available for reinvestment.

Investors have a choice between fixed- and variable-rate Tessas. Five years ago, when interest rates were high, most people plumped for variable- rate accounts, then offering 15 per cent or more. But rates have slipped towards 6 per cent, so Tessas have grown by substantially less than savers were originally led to expect.

This time around, fixed rates may look more attractive. A fixed-rate Tessa will give you certainty of return, but will leave you vulnerable to a sharp rise in inflation or interest rates.

Most Tessa providers are currently offering between 6 and 7.5 per cent a year. In general, the higher rates are available from fixed-rate accounts aimed at investors rolling over existing Tessas, whereas the lower rates are paid on variable-rate schemes for new savers. At best, the Northern Rock is offering a variable rate of 8 per cent for a follow-on Tessa with the maximum pounds 9,000 investment.

o PEPs. By investing in the stock market, PEPs offer the potential for much better returns than Tessas - though savers must be prepared for the value of their investment to fluctuate. Over the long term, however, shares have consistently outperformed deposit-based savings accounts.

Investors can put pounds 6,000 a year into a PEP - and another pounds 3,000 if they are willing to invest this additional sum in just one company. Many investors prefer to use Peps to buy unit trusts or investment trusts - collective funds that reduce stock-market risks by spreading their money across a portfolio of companies. Although most suitable as medium- or long-term investments, Peps can be cashed in at any time.

o Pensions. Savings invested in a pension scheme not only escape income and capital-gains tax within the fund, but also attract relief on the initial investment.

Pensions can provide an attractive tax-free lump sum on retirement. However, they are an inflexible form of investment - you will not be able to draw on your money until you retire.

o Friendly society policies are tax-free for savings of no more than pounds 270 a year.

o The enterprise investment scheme, a replacement for the BES, offers 20 per cent upfront tax relief on investments in new shares issued by certain kinds of privately-owned businesses.

o Venture Capital Trusts. Income- and capital-gains tax reliefs are available on investments in VCTs, which are also designed to encourage backing for unquoted companies.

o Offshore funds, companies and trusts offer tax-planning possibilities, but for investors who live in the UK merely delay the payment of tax.