Zero-Coupon Bonds

Zero-coupon bonds are a discounted form of the more traditional type of bond. They can often be purchased at a price significantly lower than the security's face value. In return, the issuer of the security does not make interest payments throughout the security's life but, at the date of maturity, combines the compounded interest accrued with the original principal to pay the investor the full face value amount of the bond. In contrast to more traditional investments, zero-coupon securities are characterized by the initial discounted purchase, compounded interest that accrues over the full life of the bond rather than periodic payments, and payment of the full face value at the security's date of maturity.

Examples of zero-coupon bonds include U.S. Treasury bills and U.S. savings bonds.

Taxation of Zero-Coupon Bonds

With zero-coupon bonds, you do not receive any interest payments until the date of bond maturity. The Internal Revenue Service, however, taxes the assumed interest payments on the bond each year rather than deferring tax payment until the bond value is realized at maturity. Therefore, zero-coupon bond holders are responsible for the implied annual interest of their investment that they will receive when the bond matures. The exception to this exists in any tax-deferred account, such as in retirement accounts, where the account holder is relieved of any tax obligations.

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Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk, credit risk, market risk, default risk, event risk and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available at Investors should read these carefully.

The material provided in this presentation is for informational purposes only and its use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security, type of security, or pursue a specific strategy. Investors should fully research any security or strategy before making an investment decision.

Scottrade does not provide tax advice. The material provided in this article is for informational purposes only and Scottrade is not responsible for any errors or omissions. Contribution and income limits are subject to change without notice. Please consult your tax, or legal, advisor for questions concerning your personal tax or financial situation.