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Unconventional Wisdom: Zero Coupon Bonds in a Taxable Account

“Zero Coupon Bonds” are bonds (typically U.S. Treasury bonds) that make no periodic interest payments. Rather, they are sold at a deep discount from their face value. Buyers of zero coupon bonds receive the full face value at maturity: the longer the time to maturity, the deeper the discount. They receive their investment return by the gradual appreciation of the bond between the time of purchase and maturity (or redemption, if sold prior to maturity).
 
Because the future value of the bond is known with certainty in advance and can be bought at a discount today, they are a popular vehicle for investment strategies that require a predetermined amount of money at some terminal point in time, such as retirement or at the start of a child’s college education. For example, a parent wanting to accumulate $10,000 by the start of his or her child’s freshman year of college in, say, 11 years, could buy a $10,000 zero coupon bond maturing in 11 years for approximately $6,000 today (11/2005).
 
Barron’s Dictionary of Finance and Investment Terms (6thEd.) notes that “For tax purposes, the Internal Revenue Service maintains that the holder of a zero-coupon bond owes income tax on the interest that has accrued each year, even though the bondholder does not actually receive the cash until maturity…Because of this interpretation, many financial advisors recommend that zero-coupon securities be used in individual retirement accounts or Keogh accounts, where they remain tax-sheltered” (799-800).
 
While this may be an effective strategy for avoiding current income taxes on the “imputed interest,” I submit to you that it shifts the burden of paying these taxes from the present – during which time earned income is likely sufficient to service the liability – to the future – in retirement, for example, during which time it becomes increasingly difficult to manage the burden of income taxes on a fixed income. Consequently, I think that for many investors it makes more sense to hold the zero coupon bonds in a taxable account and pay the income tax liability as it accrues, rather than defer it until retirement, when all distributions (from deductible IRAs and/or qualified retirement savings plans) will be fully taxable at ordinary income tax rates. Too much ordinary income from sources such as qualified retirement plans might also cause the retiree to miss out on other valuable benefits, such as the zero percent marginal tax bracket or the STAR exemption.
 
Investors wishing to accumulate a set sum of money at retirement can purchase zero coupon bonds every year (or every few years) during their working lifetime, with the various maturities scheduled to coincide with the planned date of retirement, thereby ensuring that the desired sum of money will be available when needed. Taxes on the imputed interest can be paid as they accrue, each year, while the investor is still working and while cash flow to service the liability is plentiful. At or near the time of retirement, when the bonds mature, the investor may consider whether other strategies – such as the purchase of an immediate fixed annuity to guarantee lifetime income, or reinvestment of the zero coupon bond proceeds in a mix of tax-free municipal securities – are appropriate.
 
Owning zero coupon bonds in a taxable account may defy the conventional wisdom, but it can help investors to accumulate a desired sum of money at retirement, while helping retirees to manage their tax burden through retirement.

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