Zero Coupon Bonds Tax Implications
Even though zero coupons provide many opportunities to their holders they lack tax efficiency. Therefore, you should deal with them with great caution.
Zero coupon bonds are suitable for meeting investment goals that are in the long-term, such as planning for the education needs of your children. Zeros are characterized by the fact that holders don't receive any interest payments while they possess them. Only after they reach maturity zero bondholders are paid the accumulated interest. This lack of interest payment during possession is compensated by the fact that zeros are purchased at deep discount.
Since you are not paid interest while you hold zeros, the amount is accumulated throughout the time. Therefore, it is the right choice of investment if you foresee that you will need a lump sum of money at a particular point in the future.
On the other hand, a secondary market exists about zeros, which means that you can sell them when you feel the need to. The value of the zero will be determined by the levels that prevail at the moment of sale, as well as the years that remain until it reaches maturity and the issuer's credit worthiness.
The good news concerning zero bonds is that you can hold them as long as maturity is reached. In this way you will insure yourself against the volatility of the stock market. Since you get your money back after maturity is reached you lose nothing.
Zero Bonds Taxation
Even though you are not paid the interest you have gained throughout the year, you are required to pay taxes. The rate is the same as the one you are charged on regular bonds. The amount you are liable to is announced by the issuer of the zero bonds.
In order to free your interest that you don't get at the end of the year but is still taxed, you can invest in municipal zeros that are exempt from federal income taxes. Some of them are even exempt from federal and local taxes.
Additionally, you can make zero coupon bonds part of your retirement portfolio and in this way free the interest from taxes.
Another tactic that can be applied is to put the zero bonds on the name of the child. This can be done only if the bond is used for the purposes of financing the child's education. The opening of a custodial account is required. By using this technique the tax liability is delayed and after this it is charged at the child's rate. This is so since the limits on investment income for children are lower.
The good news about tax implications concerning zeros is that once it matures, the taxes you have paid throughout the years are returned.
In case you can put up with the taxes you have to pay, the investment in zero coupons represents a good solution to the need of allocating money for a future financial goal that requires more resources as part of its achievement.
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