Zero-coupon CDs: What they are and how they work

Advertiser disclosure: Content provided by Bankrate.com. Fox and its content partners earn compensation from the affiliate companies below. This content doesn’t include all available offers, and compensation may impact how and where links appear in the content.

Investing often involves balancing high-return, high-risk strategies with more conservative approaches. However, balancing your investment strategy with a more low-risk approach can safeguard your money and long-term financial stability.

Enter the zero-coupon CD: a lesser-known but potentially powerful tool for investors. This unique twist on the familiar certificate of deposit (CD) benefits those willing to play the long game.

To understand whether zero-coupon CDs might fit into your investment strategy, let's first explore how they work.
 

How do zero-coupon CDs work?

A zero-coupon CD is a certificate of deposit that you purchase at a discount from its face value and receive the full face value when it matures, without periodic interest payments.

A zero-coupon CD shares similarities with a traditional CD. You commit to locking in your funds for a set period until the CD's maturity date. While this restricts access to your money, CDs usually have higher interest rates than standard savings accounts.

The key difference is how you receive your returns. You purchase a zero-coupon CD at a discount from its face value and receive the total value when it matures.

Jovan Johnson, a certified public accountant and certified financial planner, explains, “Unlike traditional CDs where interest compounds daily or monthly and pays out regularly, zero-coupon CDs accumulate all interest until the end of the term.”

Johnson provides the following example: Let’s say you buy a five-year CD for $4,000 with a face value of $5,000. At maturity, you’ll receive the full $5,000, a profit of $1,000.

Zero-coupon CDs typically offer longer terms than traditional CDs, which usually range from three months to five years. This extended timeframe, combined with higher interest rates, allows for greater potential growth — but it also means committing your money for a longer period.

Advantages of zero-coupon CDs

Zero-coupon CDs offer several benefits:

• Potential for a higher return than traditional CDs: Buying a zero-coupon CD at a discount potentially yields a higher return than a traditional CD, as you don't pay full value upfront.
• Known return and principal payment at maturity: Unlike variable-rate savings accounts, zero-coupon locks in your rate of return for the whole term. Using Johnson’s example, a $4,000 investment yielding $5,000 at maturity represents a 25% return.
• No reinvestment risk for interest payments: Reinvestment risk means you might have to reinvest your earnings at a lower rate in the future. In other words, the same income level won't be there when it's time to pull the earnings from interest out. You can explore options offering higher returns or greater income when the CD matures.
• Alignment with long-term financial goals and retirement planning: The longer terms of zero-coupon CDs, including zero-coupon IRA CDs, make them potentially suitable for long-term savings goals and retirement planning. Consider how they could fit into your overall savings, investments, and income stream mix.

Disadvantages of zero-coupon CDs

Consider these potential drawbacks before investing in zero-coupon CDs:

• No regular interest payments during the term: Unlike traditional CDs, you won't receive periodic interest payments. Instead, you'll receive your earnings when the CD matures.
• Lack of liquidity and early withdrawal penalties: Like traditional CDs, your funds remain locked in until maturity, and withdrawing early typically incurs penalties.
• Interest rate risk and secondary market fluctuations: You can't withdraw from brokerage-purchased zero-coupon CDs early. Instead, you have to sell your CD on the secondary market, potentially facing difficulty finding a buyer or selling at a loss.
• Credit risk: While FDIC-insured banks, NCUA-backed credit unions, and SIPC-covered brokerages offer protection up to $250,000, carefully research and select reputable issuers. The FDIC, NCUA, and SIPC provide tools to research a brokerage or financial institution.
• Inflation risk: Longer terms increase the chance that the return on the investment will not keep pace with inflation, which could mean a potential loss in purchasing power. For instance, if you invest in a 10-year zero-coupon CD with a 4% yield, but inflation averages 3% over that period, your real return (adjusted for inflation) is only about 1%.

How to invest with a zero-coupon CD

You can purchase zero-coupon CDs at banks, credit unions, online platforms, and brokerages. Compare minimum investment requirements to find the best zero-coupon CD.

"Issuers will all have different minimums, so you'll want to compare rates and terms available," says Lawrence D. Sprung, a certified financial planner, wealth advisor, and founder of Mitlin Financial. "You'll want to understand when the CD will mature and the ultimate yield."

Another thing to look for with zero-coupon CDs before opening one is the available terms and interest rates. Zero-coupon CDs’ longer terms typically offer higher interest than shorter-term traditional CDs, but make sure you feel confident about not needing those funds for the entire period.

Consider laddering zero-coupon CDs

For long-term savings, you might consider laddering zero-coupon CDs. This strategy involves spreading your funds across several CDs with varying terms, allowing access to some funds at shorter intervals while benefiting from higher interest rates. As zero-coupon CDs usually have longer terms — say, three, four, and five-year CDs — laddering is best for long-term savings goals or retirement.

Diversification

While zero-coupon CDs can be an excellent tool for conservative investors, they shouldn't be your only investment strategy. They can play a specific role in a diversified portfolio, particularly for investors with known future expenses. For example, you might use a zero-coupon CD to save for a child's college education or to supplement your retirement income.

However, it's smart to balance these investments with other assets like stocks, bonds, and real estate to spread risk and potentially increase overall returns.

How zero-coupon CDs are taxed

Zero-coupon CDs have unique tax considerations, including 'phantom income' — taxable income you haven't yet received but owe taxes on.

"Even though you don’t receive the interest annually, you still owe taxes on the interest you've accrued each year," says Johnson. "For example, if you paid $4,000 upfront and will receive $5,000 in five years, the $1,000 gain is divided across five years. You'll be taxed on that interest yearly, even though you're not receiving money until later."

"Don't expect to claim all of the interest for the CD’s life the year it matures,” says Sprung. “You'll need to be ready to pay taxes on the accrued interest and have funds available for those taxes."

Understand the tax implications of an IRA CD

Tax-advantaged accounts, such as IRA CDs, follow different rules for zero-coupon CDs. In a traditional IRA, you pay taxes when you withdraw the money. In a Roth IRA, you pay no taxes on the growth because you've already paid taxes on the money you put in.

How to prepare for taxes on zero-coupon CDs

Sprung advises against relying on the CD to generate income to cover taxes. Instead, set aside separate funds to cover those taxes. Consider talking to a financial advisor or tax professional for specific guidance.

Consider alternatives to minimize tax liabilities

To pay less in taxes, you could use a retirement account or a regular CD. Short-term CDs (less than a year) let you use the interest to pay the taxes. For longer CDs, you'll need to pay taxes on the interest each year, even if you don't receive it yet.

Johnson suggests another strategy: “Move the interest you earned from the zero-coupon CD into a tax-advantaged retirement account like an IRA. Not only do you earn some nice interest from these savings accounts, but you also potentially get a tax deduction."

Alternatives to zero-coupon CDs

If zero-coupon CDs don't align with your financial goals, consider these alternatives:

Traditional CDs

As mentioned, traditional CDs operate similarly to zero-coupon CDs but typically offer shorter terms. Some might offer "bump-up" or "raise-up" options, allowing a one-time rate increase if the bank raises rates. They also might offer "no-penalty" CDs, meaning you can withdraw funds without an early withdrawal penalty.

High-yield savings accounts (HYSAs)

HYSAs offer significantly higher rates than standard savings accounts, often rivaling CD rates. Unlike CDs, you can access your money anytime without penalties. The average interest rate for a traditional savings account in the U.S. is 0.46%, per recent data from the FDIC. Interest rates for HYSAs can be ten times higher – if not more.

Bonds

Bonds are generally safe, long-term investments. These include government savings bonds (like Series I and EE) that last up to 30 years, as well as bonds from companies and local governments.

When deciding on any of these options, it's important to ask yourself when you need the money, says Johnson. Make sure you can withstand being without those funds for a set period.

If you're saving towards a goal you're trying to reach in five years, like purchasing a car, then a zero-coupon CD could work," says Johnson. "Because at the end of the day, you just want the highest rate and to lock up your money. You don't need it year to year. But if you need a CD ladder strategy or have nearer-term goals, you'll want access to that interest sooner.”

The bottom line

With higher interest rates and longer terms, zero-coupon CDs are a low-risk investment if you want to veer on the conservative side of investing. Their unique structure provides advantages but comes with tax implications and potential risks. Understanding these factors will help you decide if zero-coupon CDs align with your financial goals and risk tolerance.

Editorial disclosure: Opinions expressed are author's alone, not those of any bank, credit card issuer, or other entity. This content has not been reviewed, approved, or otherwise endorsed by any of the entities included in the post.