Tax Considerations for Zero Coupon Bonds

When you invest in zero coupon bonds, you do not receive any form of interest over the bonds' life spans. This form of investment creates some unique tax considerations. Here are a few things to consider about zero coupon bond taxes.

Zero Coupon Bonds

Before you can understand the taxes of zero coupon bonds, it helps to have a basic understanding of what this type of bond is. A traditional bond pays you a certain "coupon rate" or interest rate over the life of the bond. Then you get your initial investment back at the end of the investment term. With a zero coupon bond, you are not paid any interest over the life of the bond. At the end of the bond, you get the face value of the bond. The difference with this type of bond is that you can buy the bond at a serious discount to what its end value is. For example, you may only pay 70 to 80 percent of the value of the bond when you buy it. This allows you to get all of the interest at the end of the investment in one lump sum. 

Tax Considerations

Zero coupon bonds have unique tax implications. Technically, you are earning interest every year, even though you do not see it until the end of the bond term. Therefore, you have to pay the taxes on the interest every single year even though you do not get the interest until the end of the arrangement. It can, of course, be difficult for some investors to come up with money for taxes on income that they did not receive. There are ways, though, to invest in zero coupon bonds with few or no annual taxes as a result. 

Offsetting Interest Taxes

  • Retirement accounts--One great way to utilize zero coupon bonds is through a retirement account. For example, with a 401k or IRA, the interest that you earn will not be taxable until you retire. Therefore, you will not have to worry about any taxes until you take out the money upon retirement. Zero coupon bonds are a relatively safe form of investment if you choose a good company, and therefore, you will not be taking on too much risk for a retirement account.
  • Municipal zero coupon bonds--Municipal bonds are those that are issued by certain government entities like city governments and school districts. Interest that is earned on municipal bonds is not taxable. Therefore, you can simply buy the zero coupon bond and then collect your interest at the end without worrying about anything in between. 
  • Education investing--When you are investing to pay for a child's education, you could put the bond in his or her name. This will prevent a lot of the interest from being taxed, and even if it is, it will be at a much lower tax rate. 
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