Most people are familiar with traditional CDs: you deposit a fixed amount of money into a certificate of deposit for a set amount of time, and you receive a fixed, pre-determined interest rate in return. At the end of the CD term, you have the option of cashing out or rolling the CD over into another term. But did you know there are other types of CDs available, called brokered CDs?
One type of brokered CD is called a zero-coupon CD. The term “coupon” refers to interest. Zero-coupon CDs do not bear interest, but are issued at a substantial discount from face amount (also called “par amount”). Interest on the CD will “accrete” and the CD holder will be paid the par amount at the CD maturity. These CDs are eligible for FDIC insurance but only at the amount of the original price offering, plus interest at the rate quoted on the original offering.
You should only purchase brokered CDs if you plan on purchasing and holding the CD to full-term maturity, and if you can afford to pay income taxes each year on the interest. For example, if you buy a 10-year $100,000 zero-coupon CD with a 6% interest rate for $60,000, you wouldn’t receive any interest payments for those 10 years. The money is being invested instead. However, anyone considering purchasing a zero-coupon CD should be aware that even though you aren’t actually receiving the 6% interest each year, it’s considered to be “phantom” income and you still have to pay taxes on it each year. In the above example, you would have to pay income taxes on $3,600 for the first year’s interest. Each year you’ll have a higher base amount than the next, so your tax bill will also increase. If you are considering zero-coupon CDs, you should make sure in advance you have enough funds available to cover the yearly taxes.
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