Bonds with a zero coupon pay no interest for the duration of the bond’s existence. Rather, investors purchase zero coupon bonds at a significant discount to their face value, which is the amount the investor would receive when the bond “matures,” or matures.
Zero coupon bonds typically have long maturities, with many lasting ten, fifteen, or even more years. These long-term maturity dates enable a person to save for a long-term objective, such as paying for a child’s college education. A deep discount allows an investor to put up a small quantity of money that will rise over time.
In the secondary markets, investors can purchase several types of zero coupon bonds issued by a range of issuers, including the US Treasury, companies, and state and local government agencies.
Because zero coupon bonds pay no interest until they mature, their prices fluctuate more in the secondary market than other forms of bonds. Furthermore, even though zero coupon bonds do not require payments until they mature, investors may be subject to federal, state, and local income taxes on the imputed or “phantom” interest that accrues each year. Some investors avoid paying taxes on imputed interest by acquiring municipal zero coupon bonds (assuming they live in the state where the bond was issued) or the rare tax-exempt corporate zero coupon bonds.
Coupon bonds are taxed in several ways.
You must pay tax every year on the interest income received, whether you acquire the bond at face value, at a discount, or at a premium. If you bought the bond at a discount, the difference between the purchase price and the maturity price will constitute a capital gain when the bond matures. There will be a capital gain or loss if bonds are sold before they reach maturity.
How frequently is interest on zero coupon bonds taxed?
Taxable zero coupon bonds, on the other hand, are taxed each year on the amount of interest that has accrued for that year, despite the fact that the accrued interest is not paid to investors that year.
What are the advantages of zero-coupon bonds?
A zero-coupon bond is a low-cost investment that can be used to save for a specific objective in the future. A zero-coupon bond does not pay interest on a regular basis, but instead sells at a substantial discount and pays the full face value at maturity. Zero-coupon bonds are appropriate for long-term, specific financial needs that can be met in the near future.
Are capital gains possible with zero coupon bonds?
A zero coupon bond is one that pays no interest for the duration of the bond’s life. Investors buy zero coupon bonds, also known as discount bonds, at a significant discount to the bond’s face value, or par, which is the amount the bond will be worth when it matures. Rather than receiving regular coupon or interest payments, the bond’s holder receives the bond’s full face value at maturity, which includes any interest that has accrued during the bond’s life cycle.
Zero-coupon bonds are issued by a variety of entities, including state and local governments, private companies, and the United States Treasury. Capital gains taxes apply to zero coupon bonds, and some zero coupon bonds compel investors to pay taxes on the imputed interest that accrues on the bonds each year, even though the interest is not paid until the bonds mature (as part of the face value). However, zero coupon municipal bonds and a small number of corporate-issued zero coupon bonds may be tax-free.
Although there are short-term zero coupon bonds, they are designed to address specific demands on specified dates, such as education funding. Most zero coupon bonds have long-term maturity dates (115+ years). Zero coupon bonds are vulnerable to more dramatic price volatility in the secondary market than many other types of bonds since no interest is paid during the bond’s life.
How can I include a bond in my tax return?
Declare the savings bond interest alongside your other interest on the “Interest” line of your tax return if your total interest for the year is less than $1500 and you’re not otherwise required to report interest income on Schedule B. See the Schedule B Instructions for more details (Form 1040).
What bonds are free from federal taxes?
Federal income from state, city, and local government bonds (municipal bonds, or munis) is normally tax-free. However, you must record this income when you file your taxes.
In most cases, municipal bond income is tax-free in the state where the bond was issued. However, take in mind the following:
- Occasionally, a state that normally taxes municipal bond interest would exempt special bonds when they are issued.
Municipal bond income may potentially be free from local taxes, depending on your state’s regulations. For further information on the rules in your state, see a tax advisor.
Are zero-coupon bonds exempt from taxes?
Zero coupon municipal bonds (sometimes known as “zeroes”) are tax-free, intermediate- to long-term bonds that are bought at a considerable discount. Compound interest on zero coupon municipal bonds is exempt from federal income taxes and, in some cases, from state income taxes for residents of the state of issuance.
Why are zero-coupon bonds so dangerous?
Zero coupon bonds are more vulnerable to interest rate changes than bonds which pay interest semiannually since all the interest payments of zero coupon bonds are aggregated and paid at maturity. The higher the volatility, the longer the bond’s maturity.
How can I save money on savings bonds without paying taxes?
Cashing your EE or I bonds before maturity and using the money to pay for education is one strategy to avoid paying taxes on the bond interest. The interest will not be taxable if you follow these guidelines:
- The bonds must be redeemed to pay for tuition and fees for you, your spouse, or a dependent, such as a kid listed on your tax return, at an undergraduate, graduate, or vocational school. The bonds can also be used to purchase a computer for yourself, a spouse, or a dependent. Room and board costs aren’t eligible, and grandparents can’t use this tax advantage to aid someone who isn’t classified as a dependent, such as a granddaughter.
- The bond profits must be used to pay for educational expenses in the year when the bonds are redeemed.
- High-earners are not eligible. For joint filers with modified adjusted gross incomes of more than $124,800 (more than $83,200 for other filers), the interest exclusion begins to phase out and ends when modified AGI reaches $154,800 ($98,200 for other filers).
The amount of interest you can omit is lowered proportionally if the profits from all EE and I bonds cashed in during the year exceed the qualified education expenditures paid that year.
What is the major disadvantage of a corporation issuing a zero-coupon bond?
One of the most significant drawbacks of zero coupon bonds is that phantom interest must be taxed. This means that you’ll have to pay income taxes on interest that you’re not getting.