How Are Zero Coupon Bonds Taxed? A Detailed Tax Breakdown

Zero-coupon bonds are a unique investment that does not pay periodic interest. Instead, they are sold at a discount and mature at face value, with the difference representing the investor’s return. While this structure simplifies cash flow, it introduces specific tax implications that investors must understand.

Taxation on zero-coupon bonds can be complex because investors may owe taxes on income they haven’t received in cash. This article explains how these bonds are taxed throughout their holding period, including annual reporting requirements, potential tax consequences if sold early, and differences based on the issuer.

Original Issue Discount

Zero-coupon bonds are issued at a discount to their face value, creating what is known as original issue discount (OID). The IRS treats this discount as taxable income, requiring investors to recognize a portion of it each year, even though they receive no cash until maturity.

The calculation of OID income follows a method called constant yield accrual, which applies a fixed yield to the bond’s adjusted cost basis each year. This results in taxable income increasing over time as the bond approaches maturity. For example, if an investor buys a 10-year zero-coupon bond for $6,000 with a face value of $10,000, the OID is $4,000. Instead of reporting the entire amount at maturity, the investor must recognize a portion annually based on the bond’s yield to maturity.

OID income is taxed as ordinary income, subject to the investor’s marginal tax rate, which can be as high as 37% in 2024. Some states also tax OID income, while others, such as Texas and Florida, do not impose a state income tax.

Annual Reporting

Investors must report taxable income from zero-coupon bonds each year, even though they receive no cash payments. Financial institutions issue Form 1099-OID to bondholders, detailing the amount of OID that must be reported as income. The IRS requires this to ensure that investors recognize taxable earnings on an accrual basis rather than deferring all income until maturity.

The amount reported on Form 1099-OID is based on the bond’s increasing adjusted cost basis, which grows annually as interest accrues. Investors must include this income on their tax return under “Interest Income” on Form 1040. Failure to report OID income can lead to penalties and interest on unpaid taxes. The IRS monitors OID reporting, and discrepancies between tax filings and 1099-OID forms may trigger an audit or tax notice.

For those investing through tax-advantaged accounts like IRAs or 401(k)s, OID income does not generate immediate tax liability, as earnings grow tax-deferred. This makes retirement accounts a useful option for holding zero-coupon bonds, as it eliminates the burden of paying taxes on income that has not yet been received. Investors should still track the bond’s cost basis to ensure accurate tax treatment upon withdrawal.

Selling Before Maturity

Selling a zero-coupon bond before maturity can lead to tax consequences, particularly when determining gains or losses. Since these bonds accrue value over time rather than paying periodic interest, their market price fluctuates based on interest rates, time remaining until maturity, and overall bond market conditions.

The adjusted cost basis is calculated by adding the previously recognized OID income to the bond’s original purchase price. This means that even if a bond is sold for more than its initial purchase price, it could still result in a capital loss if the sale price is lower than its adjusted basis. For example, if an investor buys a zero-coupon bond for $5,000, recognizes $3,000 in OID over several years, and then sells it for $7,500, they would realize a $500 capital loss ($7,500 sale price – $8,000 adjusted basis).

Capital gains or losses are categorized as either short-term or long-term, depending on the holding period. If the bond is held for more than a year before being sold, any gain is taxed at the lower long-term capital gains rates, which range from 0% to 20% in 2024, depending on income level. Short-term gains are taxed as ordinary income. Losses can be used to offset other capital gains or, if total capital losses exceed gains, up to $3,000 of ordinary income per year, with any remaining losses carried forward to future tax years.

Taxation at Maturity

When a zero-coupon bond matures, the investor receives a lump sum equal to the bond’s face value. By this point, all taxable income from the bond’s OID has already been reported incrementally over the years.

At maturity, the IRS considers the final redemption payment a return of principal rather than new taxable income. Since the adjusted cost basis of the bond matches its maturity value due to prior OID accruals, there is typically no additional federal tax liability. However, investors should ensure that their tax records accurately reflect the cumulative OID reported in previous years to avoid discrepancies with the IRS.

State taxation varies. Some states fully or partially exempt income from certain zero-coupon bonds, particularly if issued by that state’s government or municipalities. Investors should verify their state’s tax treatment, as some jurisdictions may still impose taxes on the accrued income.

Tax Treatment for Different Issuers

The tax treatment of zero-coupon bonds depends on the issuer, as different entities are subject to distinct federal and state tax regulations.

Corporate

Zero-coupon bonds issued by corporations are fully taxable at both the federal and state levels unless the investor resides in a state without an income tax. OID accrual is classified as ordinary income, taxed at the investor’s marginal rate, which can be as high as 37% in 2024. Since corporate bonds carry credit risk, they often offer higher yields than government-issued alternatives, but this additional return is fully subject to taxation.

If a corporate zero-coupon bond is purchased on the secondary market at a discount to its adjusted cost basis, the difference between the purchase price and the bond’s accrued value may be treated as market discount. Under IRS rules, market discount is taxed as ordinary income when the bond is sold or matures unless the investor elects to accrue it annually. Investors should also consider the impact of the Net Investment Income Tax (NIIT), which imposes an additional 3.8% tax on high earners with significant investment income.

Treasury

U.S. Treasury-issued zero-coupon bonds, such as STRIPS (Separate Trading of Registered Interest and Principal Securities), offer a tax advantage at the state and local levels. While OID income is subject to federal taxation, it is exempt from state and local income taxes, making these bonds particularly attractive to investors in high-tax states like California and New York.

Treasury STRIPS are backed by the full faith and credit of the U.S. government, eliminating credit risk. However, their tax treatment can create cash flow challenges for investors holding them in taxable accounts, as they must pay federal taxes on imputed interest without receiving periodic payments. To mitigate this issue, many investors purchase STRIPS in tax-advantaged accounts such as IRAs or 401(k)s, where taxes are deferred until withdrawals begin. Unlike corporate bonds, Treasury STRIPS do not carry market discount rules, simplifying tax reporting for secondary market purchases.

Municipal

Municipal zero-coupon bonds provide a tax benefit, as their OID income is generally exempt from federal income tax if issued by a state or local government for public purposes. This makes them appealing to high-income investors seeking tax-free income. Additionally, if the investor resides in the issuing state, the income may also be exempt from state and local taxes.

However, not all municipal zero-coupon bonds offer full tax exemption. If the bond is classified as a private activity bond, the OID income may be subject to the Alternative Minimum Tax (AMT), which applies to certain high-income taxpayers. Investors should verify whether a municipal bond is AMT-exempt before purchasing. Additionally, if a municipal bond is purchased at a discount in the secondary market, the market discount may be taxable as ordinary income upon sale or maturity, similar to corporate bonds. Understanding these nuances is essential for maximizing after-tax returns.