Are US Treasury zero coupon bonds taxable?
Zero-coupon Treasuries are taxed as if you were receiving annual interest income, even though you won't receive any income until the bond matures.
You owe tax each year on the prorated difference between what you paid for the bond and what you'll receive when it matures. This makes zeros attractive primarily to people with IRAs, which doesn't require you to pay tax until you take the money out.
If a zero-coupon bond is held for 12 months or more, it is treated as a long-term capital asset. Proceeds on maturity less cost of acquiring the bonds will then be taxed as long-term capital gain.
Although you don't receive this interest until you sell the bonds, the interest is reported to you every year on form 1099 OID as taxable interest income. Your cash balance is increased by the interest income and then decreased by the return of capital.
Interest from corporate bonds and U.S. Treasury bonds interest is typically taxable at the federal level. U.S. Treasuries are exempt from state and local income taxes. Most interest income earned on municipal bonds is exempt from federal income taxes.
While you'll be able to buy zeros at deep discounts to face value, you won't receive anything in return for your investment until the term of the bond ends. Along the way, you'll be subject to higher levels of interest rate risk (if interest rates rise) and inflation risk (if prices rise generally in the economy).
For example, you might pay $3,500 to purchase a 20-year zero coupon bond with a face value of $10,000. After 20 years, the issuer of the bond pays you $10,000. For this reason, zero coupon bonds are often purchased to meet a future expense such as college costs or an anticipated expenditure in retirement.
Zero coupon bonds are subject to an unusual taxation in which the receipt of interest is imputed each year, requiring holders to pay income taxes on what is called “phantom income.”
Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income.
Interest from Treasuries is generally taxable at the federal level, but not at the state level. Interest from munis is generally exempt from federal taxes, and if you live in the state where the bond was issued, the interest may also be exempt from state taxes.
Are zero coupon bonds taxed as income or capital gains?
Zero coupon bonds are subject to capital gains taxes and some zero coupon bonds require investors to pay taxes on the imputed interest that accrues on the bonds each year, even though that interest is not paid until maturity (as part of the bonds' face-value).
Zero-coupon bonds offer unique investment opportunities for various investor profiles, with their predictable returns, lower initial investments, and lack of reinvestment risk. However, these bonds also present certain challenges, such as interest rate risk, credit risk, and tax implications.
If you bought the bond when it was issued at its original issue price and hold it until maturity, you generally will not recognize a capital gain (or loss). As a result, you likely won't incur any capital gains tax.
If you invest in TreasuryDirect, your 1099 will be available electronically and you can print the form from your account. 1099 forms are available by January 31 of each tax year.
Key takeaways. Treasury bills have short-term maturities and pay interest at maturity. Treasury notes have mid-range maturities and pay interest every 6 months. Treasury bonds have long maturities and pay interest every 6 months.
For bonds with very small discounts: If the discount is less than 0.25% of the bond's face value times the number of years to maturity, the discount is taxed as a capital gain in the year the bond matures.
These bonds are issued at a deep discount and repay the par value, at maturity. The difference between the purchase price and the par value represents the investor's return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.
The Difference for Investors
A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. With a normal yield curve, long-term bonds have higher yields than short-term bonds.
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond "matures" or comes due.
Key Takeaways
Interest from Treasury bills (T-bills) is subject to federal income taxes but not state or local taxes. The interest income received in a year is recorded on Form 1099-INT. Investors can opt to have up to 50% of their Treasury bills' interest earnings automatically withheld.
Can a zero-coupon bond sell at a discount?
A zero coupon bond generally has a reduced market price relative to its par value because the purchaser must maintain ownership of the bond until maturity to turn a profit. A bond that sells for less than its par value is said to sell at a discount.
As a zero-coupon bond does not pay periodic coupons, the bond trades at a discount to its face value.
There is a special tax treatment of zeroes. The difference between the price and par is called the discount, which the buyers must then amortize as taxable income over the life of the bond. Corporations are allowed to amortize the discount as interest expense, although no cash payments of interest are made.
Zero coupon bonds offer the entire payment at maturity but tend to fluctuate in price much more compared to other types of bonds. Because you can purchase the bond at a reduced price, your earnings come from when the bonds mature.
The idea of STRIPS is that the principal and each interest payment become separate securities that are treated individually. Each separated piece is a zero-coupon security that matures separately and, has only one payment.
