Zero-Coupon Bonds and Your IRA

QUESTION: I have less than two months to go to tax time, and my wife and I still haven’t decided where to put our IRA money this year. The last two years, we have taken the easy way out and put it in a certificate of deposit at our bank. But this year, a lot of my friends are buying zero-coupon bonds with their IRA money, and for that reason alone my wife and I are thinking of doing the same. Can you tell me something about them and why they are considered good IRA investments?--F.S.

ANSWER: Zero-coupon bonds, so called because the investor receives no annual interest from them, are popular because they can be acquired for a fraction of their face value and because your money compounds annually and is automatically reinvested at the same high rate you locked in with your initial investment.

This is not the investment for those who need a regular interest check--there isn’t one. Your money continues to build up, but you don’t get any of it until the end of the bond’s term, which typically is 10 years or longer. (If the zero is a corporate or U.S. Treasury zero and isn’t put in an IRA or other tax shelter, the yearly buildup must be reported to the IRS each year as taxable income even though you receive no funds. That is not the case if the zero is a municipal bond zero, which is free from federal income taxes because its income comes from a municipal security.)

Since you are thinking about a zero as a long-term retirement savings vehicle, one which you theoretically contribute to and then put out of your mind until retirement, the zero’s primary drawback isn’t pertinent to you.

You are much more interested in how much money you would have accumulated in your zero-coupon account by the time you retire. Here is an example.

Say you buy a zero yielding 10% with a face value of $1,000 and due in the year 2005, 20 years from now. You would have to pay only $142 for that bond, which would yield you $1,000 20 years from now. The difference is compound interest. If the zero is a Treasury-based zero, you would pay federal taxes when you withdraw the money, just as you do with any other IRA contributions. But if the zero is a municipal bond zero, the interest accumulated is totally tax-free because municipal securities are exempt from federal taxation.

A $2,000 zero yielding 11%, which is typical right now, would double in value every 6 1/2 years and be worth more than $25,000 in 25 years. And if you had $5,000 to invest and 40 years until retirement, your initial investment would grow to nearly $430,000 if you put it in a zero yielding 11%.

Another important feature of the zero is the absence of reinvestment risk. With a normal bond, there are no guarantees that the interest earned on your initial investment will be reinvested at the same high rate at which your principal was invested. With zeros, the initial rate cannot be changed during the life of the investment and is the rate at which your money compounds for the entire term of the bond.

Nor does this have to be a risky investment. If you buy a zero based on Treasury bonds or notes, you have Uncle Sam backing the investment. And if you buy a corporate or municipal zero, you simply do the same homework as you would buying any other type of bond. Check the ratings given to bonds by such independent rating services as Standard & Poor’s Corp. and Moody’s Investors Service. Top-quality, triple-A rated securities are the safest, whereas the lower-rated bonds are riskier but will offer a higher yield. Take your pick.

You may buy zeroes at a brokerage firm.

Q. I have been income averaging every year for the past six years and I had tentatively figured I could again this year. But I read the other day that the averaging laws have been changed and that far fewer taxpayers will be able to use averaging to cut their taxes now. Can you tell me what the change was?--Y.E.

A. The revised rules allow taxpayers to average over only three years instead of the four years previously permitted, and they raise the threshold level to 140% of average taxable income for those years from 120% under the old rules.

Here is an example from the Research Institute of America. A taxpayer’s taxable income rose from $25,000 in 1980 to $30,000 in 1981, $35,000 in 1982 and $40,000 in 1983. Under the old law, he would have been eligible to income average if his taxable income for 1984 topped $42,000--120% of his average taxable income for the years 1980 through 1983 ($32,500) plus $3,000. (Prior law allowed a taxpayer to average if his taxable income was $3,000 higher than 120% of his average taxable income for the previous four years.)

Under the new law, he can average only if his taxable income exceeds $52,000--$3,000 plus 140% of his average taxable income for 1981-1983.

For most taxpayers that is bad news because it is harder now to qualify and reduces the benefit for those who do qualify. But a few will benefit. Again, here’s an example from the Research Institute. A taxpayer whose taxable income was $100,000 for 1980, $25,000 for 1981, $30,000 for 1982 and $35,000 for 1983 would have been able to average for 1984 only if her taxable income had exceeded $60,000 under the old law. Under the new rules, she qualifies for averaging if her taxable income is in excess of $45,000. She profits because she can throw out the large 1980 income.