Money: Tax-Free Savings - Milk, bread - oh, and an ISA, please

Getting one over on the taxman has always been difficult for the small saver. Most tax breaks appear aimed at "high net worth individuals" - a state of affairs Gordon Brown hopes to rectify with the unveiling of the Individual Savings Account (ISA).

This vehicle for small savers will eventually replace Tax-Exempt Special Savings Accounts - Tessas - as they mature after April 1999. The capital can be reinvested in an ISA and, unlike a Tessa, it can be withdrawn again without losing the tax-free status or waiting five years. What is more, instead of being sold by just building societies and banks, ISAs are likely to be available at checkouts.

Tessas were an innovation of John Major's in 1991, when he was Chancellor of the Exchequer. They aimed to do for deposit accounts what personal equity plans (PEPs) had done for stock market investments.

Holders are allowed to salt away up to pounds 9,000 over five years, well out of the taxman's reach, on the basis of pounds 3,000 in year one, pounds 1,800 in years two, three and four, and pounds 600 in year five. All the interest earned is free of tax, but only if the capital is not touched.

If savers have a Tessa maturing after five years they may reinvest the full capital into a follow-on Tessa, although they may not reinvest any of the interest in the same way.

Most Tessas pay better interest than ordinary bank or building society savings accounts. Savers hoping to grab this higher rate for just a few years could however be hit by the early withdrawal penalties imposed by many providers. These vary from loss of interest to a pounds 50 fee.

But how good an investment has a Tessa proved to be? Anyone who bought from a high street bank, when the product was first launched, has reason to be wary of taking the plunge again. Back in the early 1990s the banks used impressive headline rates of interest to tempt customers. But as rates fell, they were left to languish throughout the rest of the five- year lock-in period. A survey by Which? showed a gap of pounds 1,100 between the best- and worst-performing Tessas from 1991 to 1996. On average, bank Tessas returned pounds 300 less than those with building societies as the rates of interest offered by the banks fell more than the deposit rates of the societies.

Since 1996 providers have devised a variety of innovative Tessas in an attempt to be seen to be offering a superior product. Many now offer fixed- rate as well as variable-rate schemes.

These looked promising when they were launched in January 1996 as interest rates were lower. Now interest rates have begun climbing once more, those in a fixed-rate product could be set to lose out. Analysts point out that interest rates must average lower than the fixed rate throughout the five- year term if a fixed-rate Tessa is to be worthwhile. Currently interest rates are just not high enough to justify buying into a fixed-rate product.

In addition, withdrawing from a fixed-rate Tessa before five years can be expensive. For example, Norwich & Peterborough and West Bromwich building societies charge 120 days loss of interest and 180 days loss of interest plus a 28-day notice period respectively.

Some companies introduced "escalator" Tessas, which give progressively higher rates. Woolwich, for example, pays 5.75 per cent in the first year, followed by 6.5 per cent, 7 per cent, 8 per cent and 9 per cent in years two to five. Averaged out, however, the total return over the full term is unlikely to be exceptional.

Another innovation is the equity-linked Tessa, which allows investors a limited exposure to the stock market, using derivatives tied to a UK market index, typically the FT-SE 100.

HSBC/Midland, Bristol & West, Birmingham Midshires and Abbey National all offer this sort of product. Midland, for example, pays 5 per cent per annum simple, not compound, interest. Savers can receive an additional bonus but only if the stock market grows more than 25 per cent in five years. If the stock market climbs as much as 55 per cent the bonus reaches a maximum of 30 per cent.

But equity-linked Tessas either have onerous penalties if you need to withdraw money before the five years or do not permit withdrawals at all. They also, of course, expose investors to risk.

The best choice for most Tessa savers would appear to be the plain vanilla variable-rate product. Some of the best rates are offered by Sun Banking Corporation and Investec Bank - 7.85 per cent for first time Tessas. Staffordshire Building Society pays 7.85 per cent while the Yorkshire Building Society offers 7.8 per cent for follow-on Tessas.

According to research by MoneyFacts and the Consumers' Association, the top performers in the Tessa stakes over the first five years were small or little-known banks or building societies, not the household names.

But the introduction of ISAs, especially if they are sale at the supermarkets, could see the market for Tessa-like deposit accounts grow rapidly.

q Contacts: HSBC/Midland, 0800 369000; Bristol & West, 0117 979 2222; Birmingham Midshires, 0645 720721; Abbey National, 0800 100801; Investec Bank, 0171 203 1650; Sun Banking Corp, 01438 744505; Staffordshire BS, 01902 317485; Yorkshire BS, 0800 378836; Woolwich, 0800 222200; Norwich & Peterborough BS, 0800 883322; West Bromwich BS, 0990 143668.