Municipal bonds are commonly tax-free at the federal level, but can be taxable at state or local income tax levels or under certain circumstances. A municipal bond, also known as a muni, is a debt security used to fund capital expenditures for a county, municipality or state. One of the major advantages of munis is that they are typically exempt from federal income tax. Municipal bonds, because they are tax-exempt, are popular among individuals in higher income tax brackets. While munis are generally assumed to be tax-free, investors should determine a bond s tax consequences before investing.
- Municipal Bond Forum
- Types of Bonds
- Should I Invest in Zero Coupon Bonds?
- How are municipal bonds taxed?
- Bond Basics: Zero-Coupon Bonds
- Zero-Coupon Municipal Bonds
- Zero Coupon Municipal Bonds: Tax Treatment
- What is the Pennsylvania tax treatment of zero-coupon municipal bonds?
- Municipal Bonds
- Coupon (bond)
Municipal Bond Forum
Most people think of bonds as being appropriate for those who need regular current income without a huge amount of risk. Yet some bonds are structured specifically not to pay income currently. The special ways in which these zero coupon bonds work can make them appropriate for very different uses than the typical fixed-income security. With most bonds, the issuer accepts an up-front payment from investors in exchange for promising to pay interest payments at regular intervals and then repay the principal at maturity.
Zero coupon bonds work a bit differently. As the name suggests, the issuer has no obligation to make any interest payments during the term of the bond. Only at maturity must the issuer repay the face value of the bond. As you can imagine, investors aren t willing to pay the same amount for a zero coupon bond that they would for a bond that pays interest. Zero coupon bonds are therefore sold at a discount to their face value.
There are two very different reasons why various investors like zero coupon bonds. For one group, the absolute certainty of receiving a fixed amount on a fixed date in the future is extremely valuable. Another group of investors likes zero coupon bonds because of their sensitivity to rate changes. Because all of the return of a zero coupon bond gets incorporated into its price, changes in rates have a more dramatic impact on zero coupon bond prices than with their interest-paying counterparts.
The longer the maturity, the greater the price sensitivity. Therefore, if you want to bet on interest rates moving a particular direction, zero coupon bonds are your best way to maximize profit from any given rate move. For some investors, being more sensitive to rate changes is a negative rather than a positive. If you don t intend to hold your bond to maturity, you have to stay aware of market fluctuations, and extreme volatility for zero coupon bonds can work against you if rates don t move the way you want.
Specifically, if rates rise, they make the value of your zero coupon bond go down, potentially forcing you to sell at a depressed price if your timing is bad. Another problem with zero coupon bonds is that IRS laws typically force you to recognize taxable income every year. Despite the fact that you don t actually receive an interest payment in cash, the IRS requires you to impute the amount of interest you should have gotten, based on the initial yield.
Fortunately, you might be able to avoid this issue by holding zero coupon bonds in a tax-favored account like an IRA. Despite their dangers, zero coupon bonds let you do some unusual things. Rate speculation can be risky, but the rewards can be impressive if you make the right bet. Meanwhile, if you have specific cash needs at a given time that you don t want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals.
Dan Caplinger has been a contract writer for the Motley Fool since As the Fool s Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool. With a background as an estate-planning attorney and independent financial consultant, Dan s articles are based on more than 20 years of experience from all angles of the financial world. Follow DanCaplinger. Skip to main content Helping the world invest better since Hi, Fool!
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Types of Bonds
Most people think of bonds as being appropriate for those who need regular current income without a huge amount of risk. Yet some bonds are structured specifically not to pay income currently. The special ways in which these zero coupon bonds work can make them appropriate for very different uses than the typical fixed-income security. With most bonds, the issuer accepts an up-front payment from investors in exchange for promising to pay interest payments at regular intervals and then repay the principal at maturity. Zero coupon bonds work a bit differently. As the name suggests, the issuer has no obligation to make any interest payments during the term of the bond.
One of the niche offerings in the debt securities market is the zero coupon bond. It s possible to find these investments issued by the U.
Zero-coupon bonds were introduced to the fixed-income market in as a very unique concept in the marketplace. Having a complete understanding of zero-coupon municipal bonds means becoming acquainted with the principal characteristics of both municipal bonds and the zero-coupon structure. Instead, the investor receives one payment at maturity that is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. Discount bonds are sold at a substantial discount from the face amount.
Should I Invest in Zero Coupon Bonds?
There are as many kinds of zero-coupon securities as there are bonds, plus a number of interesting variations. Corporate zeros: These are corporate bonds, done zero-style. Because you are buying into the credit risk of the corporation, corporate zeros are the most risky kind of zero coupon. These are even riskier than a corporate coupon bond or registered bond , because if the issuing company defaults on the zero, the holder receives no interest at all. Strips are zeros that are backed by government securities and offered by brokerage houses. Brokerages are proliferating their own proprietary brands of strips under a dizzying array of acronyms:
How are municipal bonds taxed?
I have a variety of zero coupon municipal bonds. Some are issued in Pennsylvania and are tax-free. I also hold some out of state, such as Harris County, Texas, which is also a zero-coupon municipal bond. What is the Pennsylvania tax treatment for this bond? I was originally going to pay the 3. Is this correct, as it was held to maturity? I have other out-of-state bonds that I was going to treat this way, but my brokerage statement is showing the tax-exempt interest as original issue discount. What is correct for Pennsylvania treatment? Interest on obligations of other states, territories, and their political subdivisions and instrumentalities is taxable for Pennsylvania personal income tax purposes. Zero-coupon bonds don t have coupons, so they don t make annual interest payments.
Bond Basics: Zero-Coupon Bonds
I have been trying to determine whether zero-coupon municipal bonds are subject to market discount rules for taxation purposes. In short, is the buyer of a zero-coupon muni held to maturity ever subject to federal taxes other than the alternative minimum tax? Although the short squeeze wasn t as quick and swift as we thought it might be, it didn t disappoint in the end. Markets where the Russell outperforms are healthier than those where it doesn t. Taken together they create a worrisome picture, one that can explain why it wasn t just the banks that fell on the inversion news. All rights reserved.
Zero-Coupon Municipal Bonds
Important legal information about the email you will be sending. By using this service, you agree to input your real email address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an email. All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity. Municipal bonds are debt obligations issued by public entities that use the loans to fund public projects such as the construction of schools, hospitals, and highways. Open an Account. In general, municipal bonds fall into one of two categories—general obligation or revenue bonds. This categorization is based on the source of their interest payments and principal repayments.
Zero Coupon Municipal Bonds: Tax Treatment
The municipal bond market began as a general obligation market similar to the Treasury market After a decade-long fiscal decline, Puerto Rico filed for bankruptcy protection and has been in The municipal bond market has experienced its fair share of headwinds over the past few years, We are providing certain data supplied to us by the Municipal Securities Rulemaking Board "the Service" without warranties or representations and on an "as-is" basis. You shall bear all risk, related costs and liability and be responsible for your use of the Service. The transaction data provided through the Real-Time Transaction Subscription Service represents municipal securities transaction data made available by brokers, dealers, and municipal securities dealers to the MSRB and related information. The MSRB, its officers, directors, employees, agents, consultants, and licensors shall not be liable or responsible to you or anyone else for any losses, injuries, damages, costs, expenses or claims caused by, arising out of or relating to the following: The MSRB and its officers, directors, employees, agents, consultants, and licensors shall have no liability in tort, contract, or otherwise and as permitted by law, product liability to you or anyone else for any reason associated or in connection with, resulting from or arising out of your use of the Service.
While most municipal bonds provide semiannual interest payments, zero coupon bonds, as their name suggests, have no coupon or periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the principal invested plus the interest earned, compounded semiannually at a stated yield.
What is the Pennsylvania tax treatment of zero-coupon municipal bonds?
That s why this special class of bonds is called zero-coupon CDs. This simple difference between the two investments causes various consequences that favor certain types of investors. Holders of zero-coupon bonds don t receive any coupons, or interest payments, over the life of the investment. In return, investors can buy zero coupon bonds at a large discount on the face value. They essentially earn their return as the difference between the discounted price and the face value of the zero coupon bond. Regular bonds , however, provide regular interest payments to the bondholder, and at maturity, the bondholder receives the face value of the bond. That can seem to be a bigger advantage, but practically, the yield of zero coupon bonds is usually higher than ordinary bonds. Coupon-paying bonds usually trade near their face value, but zero coupon bonds trade based on how much interest, or equity, has accrued to enhance the value of the deeply discounted initial price. The maturity date of any bond depends on whether it s a short-term or long-term investment. Short-term zero coupon bonds usually mature within a year and are called bills. That makes them ideal for retirement savings and financing college educations.
Zero coupon municipal bonds combine the benefits of the zero coupon instrument with those of tax-exempt municipal securities and offer the following advantages:. Further, tax-exempt zero coupon municipal bonds earn interest that, in many cases, is also free from state and local taxes. Certain out-of-state municipal bonds may be taxable at the state level. Check with your tax attorney or advisor. In contrast, taxable zero coupon bonds are taxed each year on the amount of interest that has accrued for that year even though the accrued interest is not actually paid to investors in that year. Because they are sold at a substantial discount from face amount, you can purchase more zero coupon bonds for your money than other types of bonds. The greater the number of years a zero coupon bond has until maturity, the less you have to pay for it. Zero coupon bonds allow investors to invest a modest amount of money today and know exactly how much money they will receive on a specified future date.
A coupon payment on a bond is the annual interest payment that the bondholder receives from the bond s issue date until it matures. Coupons are normally described in terms of the coupon rate , which is calculated by adding the sum of coupons paid per year and dividing it by the bond s face value. The origin of the term "coupon" is that bonds were historically issued in the form of bearer certificates. Physical possession of the certificate was proof of ownership. Several coupons, one for each scheduled interest payment, were printed on the certificate. At the date the coupon was due, the owner would detach the coupon and present it for payment an act called "clipping the coupon". The certificate often also contained a document called a talon , which when the original block of coupons had been used up could be detached and presented in exchange for a block of further coupons. Not all bonds have coupons. Such bonds make only one payment: Normally, to compensate the bondholder for the time value of money , the price of a zero-coupon bond will always be less than its face value on any date before the maturity date.VIDEO ON THEME: FMSbonds, Inc. Tax-Free Municipal Bond Specialist