Zero coupon bonds are a form of investment that many investors have turned to as part of a diversified portfolio. Zero coupon bonds present a unique spin on the bond investment. Here are the basics of how zero coupon bonds work and how you could utilize them as part of your portfolio.

Zero Coupon Bonds

With traditional bonds, you loan a corporation or the government a sum of money. They pay you a specified amount of interest over the period of the bond. They send you regular interest payments for your investment and then at the end of the term, you cash in the bond for your initial investment back. 

While zero coupon bonds adhere to the same principles, the way that it is put into practice is a little bit different. With a zero coupon bond, you are still purchasing a bond and receiving a specified amount of interest over the life of the bond. However, the difference is that you do not actually receive any interest payments over the course of the bond. The corporation keeps all of the money and then gives you your initial investment, plus all of the interest that you received over the years at the end of the term. 

Benefit of Zero Coupon Bonds

The main benefit of zero coupon bonds is that you can invest for specific goals in the future. If you want to invest a certain amount of money and know exactly what you will get back in the future, this could be a great tool. For example, if you were investing so that you could purchase a home or pay for a child's education at a certain point, this could be a very valuable tool to use. 

Tax Implications

One thing that you will have to consider about zero coupon bonds is the tax implications that come with them. With this type of bond, you are actually responsible for the interest payments on your taxes, even though you receive no payments. This is referred to as "phantom interest" and it has to be accounted for along the way. This requires you to come up with money to pay the taxes from other sources besides the bond. Then when you get to cash in the bonds, you will not have to pay any taxes on the money. 

Ways to Minimize Taxes

  • Retirement accounts- Coupon bonds can be a great addition to a retirement account. When you buy them with your retirement account funds, you do not have to worry about taxes on the bonds. Your account is allowed to grow tax free. Then when you retire, you can worry about paying the taxes for them.
  • Education savings- When you use zero coupon bonds for education, you can actually put the bonds in the children's names. This will allow make the interest taxable at the child's rate, which will usually be much less than what your tax rate would be. 
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