In the first part of this two-part series, we looked at some of the characteristics of zero coupon bonds and some of the organizations that issue them.
In this part, well turn our attention to how to use zero coupon bonds and the tax consequences.
Like regular bonds, zero coupon bonds are great for targeting a financial need in the future for example, a childs college education or your retirement. (For more information on bonds see my article Bond Basics
Unlike regular bonds, you wont receive any interest payments along the way. The trade off is that you can buy the bonds at a great discount. This means you might only need to come up with 70% or 80% of the face value of a 20-year or longer bond.
No Interest PaymentsThis reduces your need to lay out a large sum of money upfront. The trade off is you wont be receiving any interest payments, but you will get nicked for the taxes just the same (more about taxes in a minute).
There is a secondary market for zero coupon bonds, although not a robust as for regular bonds. If you need to get rid of a zero coupon bond, its value will be determined by prevailing market rates, years remaining and credit worthiness of issuer.
Hold to MaturityThe advantage of zero coupon bonds is in keeping them until maturity. Many investors use them to provide a solid base against a volatile stock market.
For example, suppose you had $100,000 to invest. You might take $25,000 or so and buy a $100,000 STRIP (U.S. Treasury issue) maturing in 20 years.
You might then take the remaining $75,000 and invest it in stocks appropriate for your financial goals. The worst that can happen is in 20 years youll get your money back. (Of course, Ive ignored fees and taxes, but you get the point. I trust that you would do better than lose all your money.)
This very simple example may open the door to other ideas for you. For example, instead of buying one bond for $100,000, you could build a bond ladder.
Taxing SituationZero coupons are taxed just like regular bonds even though they dont pay interest until maturity. Every year the issuer will send a statement telling you how much interest accrued to the bond that year.
There are some things you can do to offset the tax on phantom interest.
- Municipal zero coupon bonds are free of federal income tax and may be free of state and local tax where issued
- Zero coupon bonds work great in retirement accounts where they can grow free from tax on current interest
- If you are using one to fund a childs college education, consider putting the bond in the childs name. Your broker can help you set up a custodial account. Because of the lower limits on investment income for children, it may take some time before any tax is owed and then at the childs rate. Be sure you check with a qualified tax professional to get this done correctly.
- Even if you have to pay tax as you go, the good news is when the bond matures, all the taxes are paid.
ConclusionZero coupon bonds can be a good choice for funding a future financial goal, especially if you dont have a large sum to put down now and can solve or live with the tax consequences.
Back to Part One