Do you pay taxes on zero coupon bonds?
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.
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.
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.
A bond's coupon rate is the percentage of its face value payable as interest each year. A bond with a coupon rate of zero, therefore, is one that pays no interest. However, this does not mean the bond yields no profit. Instead, a zero coupon bond generates a return at maturity.
Interest Is NOT Invisible to the IRS
Therefore, the IRS requires that you pay tax on this "phantom" income each year, just as you would pay tax on interest you received from a coupon bond. Learn more about bonds.
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).
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.
Municipal Bonds
Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes. In addition, interest on the bonds is exempt from State of California personal income taxes.
- Report interest each year and pay taxes on it annually.
- Defer reporting interest until you redeem the bonds or give up ownership of the bond and it's reissued or the bond is no longer earning interest because it's matured.
These long-term maturity dates let investors plan for long-range goals, such as saving for a child's college education. With the bond's deep discount, an investor can put up a small amount of money that can grow over time.
What is the benefit of a zero-coupon bond?
The Zero Coupon bonds eliminate the reinvestment risk. Zero-Coupon bonds do not let any periodic coupon payments, and hence a fixed interest on Zero Coupon bonds is guaranteed. Fixed returns: The Zero Coupon bond is a perfect choice for those who prefer long-term investment and earn a lump sum.
Gains from zero coupon bonds are subject to capital gains tax on maturity. The capital appreciation for zero coupon bonds is the difference between the maturity price and purchase price of the bond.
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. Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated short-term price movements.
To calculate the yield-to-maturity (YTM) on a zero-coupon bond, first divide the face value (FV) of the bond by the present value (PV). The result is then raised to the power of one divided by the number of compounding periods.
As a zero-coupon bond does not pay periodic coupons, the bond trades at a discount to its face value.
A zero-coupon swap is an exchange of cash flows in which the stream of floating interest-rate payments is made periodically, as it would be in a plain vanilla swap, but where the stream of fixed-rate payments is made as one lump-sum payment at the time when the swap reaches maturity, instead of periodically over the ...
Understanding the Zero Coupon Bond Yield
The yield on Zero Coupon Bonds is simply the discount rate used in the present value calculations for the bond's face value. It signifies the annualised return the investor will earn from the bond if held until maturity.
You can report the interest each year you earn it or when you cash the bond. You will report it on Schedule B of your 1040. You can avoid these taxes by using the money for qualified higher education expenses.
They are still taxable. The interest income of the savings bond will be taxed to the bond's owner—i.e., the recipient of the gift—when the bond matures and is redeemed for cash (or the owner will be taxed each year if they elect to report the interest income annually).
In general, you must report the interest in income in the taxable year in which you redeemed the bonds to the extent you did not include the interest in income in a prior taxable year.
How is bonds income taxed?
The tax rate charged will depend on how long you held the bond. If you've held it for less than a year, you'll be charged at your regular income tax rate. Bonds held for more than a year will be subject to potentially lower long-term capital gains rates.
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.
For newly issued taxable bonds purchased at an original issue discount (OID): You'll generally be required to recognize a portion of the discount each year as taxable income (known as accretion)—which also increases the cost basis of the bond—until maturity, when the cost basis equals the bond's face value.
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.
At a bank: If a bank cashes your savings bond, they are responsible for getting you a 1099-INT. They may give or mail you the 1099-INT as soon as you cash the bond or they may wait until the following January.
