Zero Coupon Bonds

[satyaa]

Zero coupon bonds don't pay and explicit interest during the life of the bond. The holder receives the full payment at maturity.

Does the holder of the zero coupun bond need to pay tax on the implicit interest rate before maturity and hence have a negative cash flow before maturity?

Thanks

 

[JoeyDVivre]

Oh yeah and it's not just zeros but other discount bonds as well. But it wasn't always true.

Originally, Merrill (I believe) in the 1970's (I believe) took a bunch of treasuries and escrowed them and sold off coupon interests as zero coupon bonds. The tax code didn't recognize the accrued interest so a bunch of treasury interest got turned into capital gains instead of income. Alas, the IRS and Congress caught on pretty quick.

Of course, that might mean that you get higher interest on them because of the cash flow disadvantage and can put them in your retirement account (anyone know the state of the world on the first part of that?).