Baccalaureate Bonds

College expenses continue to rise.  How will you pay for everything?  Do you think that student loans are the only option?  Have you considered bonds?  Baccalaureate bonds are zero-coupon bonds issued by certain states to assist families save for college tuition by means of added tax benefits.  So, they are very similar to zero-coupon bonds, but have college planning as their primary focus.  Keep reading to learn more about this specific type of zero-coupon bond.

A Quick Lesson on Bonds

There are three important terms to know as you learn about bonds, in general: the par value, the coupon rate, and the maturity date.  Knowing these terms will help you analyze the different types of bonds available and be able to compare them.

  1. Par value is the amount of money the investor will receive once the bond matures.  This means that whoever sold you the bond will return to you the original amount that was loaned, or the principal.
  2. The coupon rate is the amount of interest that the bondholder will receive expressed as a percentage of the par value.  The bond will also specify when the interest is to be paid, whether monthly, quarterly, semi-annually, or annually.
  3. The maturity date is the date when the bond issuer has to return the principal to the lender.  Once the principal is paid, the debtor is no longer obligated to make interest payments.

Limitations on Baccalaureate Bonds

Baccalaureate Bonds are very similar to zero-coupon bonds but are specifically designed for your college planning needs. These are actually ordinary zero-coupon municipal bonds. But, beware… only about 20 states issue baccalaureates. To use them you must be a resident of the state and your child must attend a state university. They work like any other tax-free zero bond except that your state will give you a discount on the tuition if you enroll in the state university and pay with these bonds.  So, keep in mind that you have to attend a state university to use baccalaureate bonds.

Zero Coupon Bonds and Taxes

Even though you do not receive any interest while holding your baccalaureate zero coupon bonds, in the U.S. the IRS requires that you calculate an annual interest income and report this income each year. Usually, the issuer of your zero coupon bond will send you a Form 1099-OID, Original Issue Discount, which lists the interest.  You should report this interest like any other interest you receive.
For capital gains purposes, the calculated interest you earned between the time you purchased and the time you sold or redeemed the baccalaureate zero bond is added to your cost basis. If you held the bond continually from the time it was issued until it matured, you will generally not have any gain or loss.


General Characteristics of Zero Bonds

Zero coupon bonds generally come in maturities from one to forty years. The U.S. Treasury issues are the most popular ones.  But here are some general characteristics of zero coupon bonds:

  • Issued at deep discount and redeemed at full face value.
  • You must pay tax on interest annually even though you don’t receive it until maturity.
  • Some issuers may call zeros before maturity.
  • With baccalaureate zero bonds, you have to use the money to pay for college expenses at a state university.