Treasury bond STRIPS are a widely available form of zero coupon bonds. These bonds do not pay regular interest; instead, a STRIP is purchased at a discount from the face value and the earnings are the difference between the cost and the maturity value. Unfortunately, the tax rules do not allow you to put off paying taxes on the earnings from your Treasury STRIPS.
According to the Treasury website, STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. The acronym is clever since these zero coupon bonds are formed by stripping out interest and principal payments of regular Treasury bonds and selling the pieces. STRIPS are created by brokerages or investment firms, but the resulting pieces of Treasury securities can be registered with and tracked by the U.S. Treasury. STRIPS do not pay regular interest. For example, at the time of publication, a 20-year, $100,000 STRIP costs $53,000 with the $47,000 difference the interest to be earned on bond.
With a zero coupon Treasury bond, you must pay taxes on the imputed or phantom interest each year. The $100,000 STRIP purchased for $53,000 has a yield to maturity of about 3.2 percent; so in the first year, the imputed interest earnings would be approximately $1,800. The broker or financial institution holding the Treasury STRIP will send you an Internal Revenue Service Form 1099-OID each year with the amount of interest you must claim on your taxes. Paying taxes annually does spread the tax bill out over the term of the bond. However, you do not actually receive interest payments that could be used to pay the taxes.
Interest earned from Treasury securities is exempt from state and local income taxes. The imputed Treasury STRIP interest you must report each year for your federal taxes is also exempt. Do not include the 1099 interest from your STRIP investments in your taxable income when filing state taxes. The state tax exemption results in a higher after-tax yield from Treasury securities when compared to other, fully taxable bonds.
The amount of interest you must claim and pay taxes on a STRIP each year adds to the cost basis of your zero coupon bonds. If you sell a Treasury STRIP before it matures, you could end up with a capital gain or loss. Capital gains are taxable and a capital loss can be used as a tax write-off. With a sold STRIP, compare your tax basis calculation with the numbers provided on the 1099 from your broker to ensure the gain or loss is accurately calculated.