- A zero coupon bond is fixed-rate investment that pays you a specified return over a prestated period of time. When you buy a standard coupon bond, the issuer pays you interest throughout the life of the bond. In contrast, the zero coupon bond pays all of its earnings at once, at maturity. You buy a zero coupon bond at a deep discount and redeem it at maturity for its face value. For example, you may pay $25 for a bond that will have a face value of $50 some years later.
- Zero coupon bonds are usually long-term investments with maturities of 10 to 30 years. United States Savings bonds are an example of zero coupon bonds. If you redeem your bond before it fully matures, you will be paid less than its face value. Your payout will be the sum of your initial investment plus the calculated earnings to date.
- Although you do not receive earnings on a zero coupon bond until it matures, or you cash out early, you are required to report "imputed" earnings on your tax return. The yearly appreciation of the bond is referred to as "phantom interest," because you don't actually receive it during the life of the bond. You will usually receive a 1099 OID (original-issue discount) form indicating the amount of implied interest you received from your bond in a given tax year. The IRS also receives a copy of the form.
- You may defer paying taxes on phantom interest by holding your zero coupon bond in a retirement account. Earnings on investments held in an IRA or a 401(k) are tax deferred until you begin making withdrawals in retirement. You may also purchase municipal zero coupon bonds that are tax-free on the federal level and often tax-free in the state in which they are issued.
- You know exactly what the value of your bond will be at maturity. You can maximize your profits by buying zero coupon bonds at different times. As interest rates rise, buy more bonds; when rates fall, invest your money elsewhere. Long-term zero coupon bonds make good investments to help meet costs like college tuition.
