Even at a young age, advisers generally suggest that you don't put all of your nest egg into the stock market. Zero-coupon CDs and bonds are two ways that you can invest your money in a way that is generally more conservative than owning stocks. Both CDs and bonds are essentially loans you make in exchange for interest payments. The timing of the interest payments is one of the main differences between zero-coupon CDs and bonds.
A bond is an investment that makes regular interest payments over the life of the bond. Typically, if you buy a bond you will receive interest twice per year, along with a return of your original investment at the bond's maturity date. A zero-coupon CD doesn't pay you any interest until the end of its term, and the interest is essentially in the form of a bonus payment. When you buy a zero-coupon CD, you pay less than the full face amount of the CD. When the CD matures, you receive the CD's full face value in place of regular interest payments. As such, a bond may be a better investment if you need regular income, but a zero-coupon CD may be more appropriate if you are saving for a future date.
Bonds and CDs are both "guaranteed" investments, but the value of the guarantee can vary wildly. A bond is a promise by a corporate or government issuer that you will receive interest payments and the return of your principal. However, if the issuer goes bankrupt or otherwise fails to live up to its obligations, you are out of luck. The promise of a bond issuer is only as good as the financial strength of the issuer. Many bonds carry ratings to reflect the ability of an issuer to repay its debts, with a higher rating reflecting more solid financials. Zero-coupon CDs, on the other hand, are issued by banks and have federal insurance in the form of the Federal Deposit Insurance Corporation. The FDIC has a fund set up to repay investors up to $250,000 per signature per account in the event a bank fails to repay investors in zero-coupon CDs.
Generally, interest received from both bonds and zero-coupon CDs is fully taxable. In the case of a zero-coupon CD, the Internal Revenue Service considers the difference between the amount you paid and the amount you receive at maturity to be taxable interest. The taxation is more complicated, but essentially you must pay tax on this interest each year even though you don't physically receive it until maturity. An exception to this rule is if you purchase a bond or CD issued by the U.S. government, in which case your interest, while federally taxable, is generally exempt from state income tax. Another exception is if you purchase a municipal bond, which is typically exempt from both federal and state income tax.
One of the main differences between zero-coupon CDs and a bonds is in the way you buy and sell them. Although some financial services firms now offer CDs, traditionally you buy a CD directly from the issuing bank. If you sell the CD back to the bank before it matures, you will owe an interest penalty. A bond is often a publicly traded instrument that you can buy and sell from a financial services firm, like a stock. Other than a possible commission on the sale, you generally do not owe any penalties for selling a bond before maturity.
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