True or false: Zero-coupon bonds accrue taxable income each year even though no cash is received until maturity.

True or false: Zero-coupon bonds accrue taxable income each year even though no cash is received until maturity.

• A. True
• B. False
• C. Only for municipal bonds
• D. Only if you sell before maturity

Answer: (A)

Zero-coupon bonds generate interest in value as time passes, even though no cash is paid out until maturity. The price of a zero-coupon bond is set below its face value, so as years go by its value accrues toward the par amount. For tax purposes, that accumulated interest—known as original issue discount (OID)—has to be reported as taxable income each year, regardless of whether you actually receive any cash. So you may owe taxes annually on phantom income while you hold the bond, and you only realize the cash when it matures and pays out at face value. In contrast, the other options miss this broad rule. It isn’t limited to municipal bonds, and you don’t need to sell the bond to owe tax—the accrual happens year by year whether or not you sell.

Zero-coupon bonds generate interest in value as time passes, even though no cash is paid out until maturity. The price of a zero-coupon bond is set below its face value, so as years go by its value accrues toward the par amount. For tax purposes, that accumulated interest—known as original issue discount (OID)—has to be reported as taxable income each year, regardless of whether you actually receive any cash. So you may owe taxes annually on phantom income while you hold the bond, and you only realize the cash when it matures and pays out at face value.

In contrast, the other options miss this broad rule. It isn’t limited to municipal bonds, and you don’t need to sell the bond to owe tax—the accrual happens year by year whether or not you sell.