Source: Bankrate
If you’re looking for ways to better diversify your financial portfolio, you might consider zero-coupon certificates of deposits (CDs). There are some tax implications you need to weigh, but zero-coupon CDs can earn higher yields than other types of CDs.
Here’s what you need to know about zero-coupon CDs.
What is a zero-coupon CD?
To understand zero-coupon CDs, you first need to know how traditional CDs work. A conventional CD comes with an interest rate and term limit you agree to in advance. Any interest that accrues is usually paid on a monthly basis.
A zero-coupon CD, in comparison, is purchased at a lower price, but you don’t receive the interest until the CD’s maturity date. So, with a zero-coupon CD, you wait longer to receive the interest earnings, but your returns could be higher than returns on a conventional CD.
This type of deposit account is called “zero coupon” because “coupon” refers to a periodic interest payment and “zero” indicates that it does not incorporate such payments.
How zero-coupon CDs work
You pay a discounted price for a zero-coupon CD in exchange for not being paid interest throughout the term. You receive the full face value of the CD once it matures. That’s your rate of return.
Let’s say you buy a zero-coupon CD with a face value of $20,000 for just $15,000. You wouldn’t receive any interest payments during the term, but you would receive the $20,000 face value when the CD matures.
“Zero-coupon CDs are typically long-term investments, which makes them ill-suited to those who are seeking a short-term timeline,” says Elliot Pepper, CPA, CFP who works as a financial planner and director of tax at Northbrook Financial in Baltimore. “If cash flow is not a big concern for you and you are more concerned about maximizing long-term yield, a zero-coupon CD could be a good product for you.”
How to invest in a zero-coupon CD
Zero-coupon CDs are typically purchased through brokerage firms, but banks sell them, too. Opening a zero-coupon CD is similar to opening a traditional CD.
You can visit a bank branch or set up an account online, depending on the bank. You’ll be asked for some personal information and to name a beneficiary for the account. You’ll also need to fund the CD, and a minimum balance may be required.
Know the date when your zero-coupon CD will mature and what your options will be for collecting your principal and interest or for renewing the CD.
Pros and cons of zero-coupon CDs
There are advantages and disadvantages to every financial product and zero-coupon CDs are no exception. Here are some pros and cons to consider before investing in zero-coupon CDs.
Pros
- Potential for higher return. One of the most significant advantages of a zero-coupon CD is that they are sold at a discounted price. You’ll potentially earn a higher return than what traditional CDs offer since you didn’t pay face value for the CD at the outset.
- Low-risk savings option. Zero-coupon CDs are a low-risk savings option with a guaranteed return, as long as you don’t withdraw the money early. Including them in your portfolio could work to your advantage if you expect interest rates to drop during the duration of the CD.
- Offers long-term strategy. Brandon Renfro, CFP and owner of Belonging Wealth Management in East Texas, says zero-coupon CDs are a good option for savers who have longer-term savings goals. “You purchase a zero-coupon CD for a lower price and collect the larger maturity value at the end of the CD’s term. That’s pretty straightforward and makes it very easy to plan for savings goals.”
Cons
- No recurring income. Since you don’t earn any interest until the CD reaches maturity, zero-coupon CDs don’t provide a recurring income. For that reason, they are not a good option for savers seeking to earn a recurring income with their investments.
- Can be callable. If you decide to buy a zero-coupon CD, be sure it isn’t callable. Callable CDs allow issuers the option to redeem the CD before it reaches full maturity. A bank may decide to take back the CD early if interest rates drop, in which case you’ll only earn part of the interest. You’ll also have to deal with the inconvenience of looking for a new place to invest your money.
- Must pay taxes on interest not yet received. The biggest disadvantage of a zero-coupon CD is you’ll have to pay taxes on the accrued interest each year even though you haven’t received it yet. As Renfro sees it, anyone looking to invest in a zero-coupon CD needs to plan for the “phantom income” you will owe taxes on along the way. The CD doesn’t pay out any interest until maturity, but it’s still reported as income you earned and have to pay taxes on every year.
Bottom line
Zero-coupon CDs are best suited for consumers looking for a safe, longer-term investment. You won’t earn any recurring income, but you’ll have to pay taxes on the interest that accrues in the meantime. Your returns, however, could be higher than what you would get with a regular CD.
— Bankrate’s Libby Wells contributed to an update of this story.