Treasury STRIPS

Client Adaeze Nwosu holds Treasury STRIPS in her TAXABLE brokerage account, purchased at a deep discount and maturing in eighteen years. She tells her IAR she likes them because they pay nothing until maturity, so there is nothing to report each year. Which statement is correct?

1. A.She is correct: because no cash is received before maturity, no federal income is reportable until the STRIPS mature.Incorrect. Original issue discount accretes and must be included in federal taxable income annually, notwithstanding the absence of any cash payment.
2. B.She is mistaken: the annual accretion of original issue discount is federally taxable each year even though no cash is received, which is why zeros suit tax-deferred accounts; the interest is, however, exempt from state and local tax.Correct. Phantom income makes a taxable account the wrong home for a zero, while Treasury status still exempts the interest from state and local tax.
3. C.She is mistaken, because the annual accretion is taxable at both the federal and the state level, exactly as corporate zero-coupon interest is.Incorrect as to the state treatment. STRIPS are Treasury obligations, so the interest is exempt from state and local income tax.
4. D.She is correct, and the STRIPS also carry less interest rate risk than a coupon Treasury of the same maturity.Incorrect on both counts. Annual OID is reportable, and a zero has the LONGEST duration for its maturity, so it carries the most interest rate risk.

Why: STRIPS are created when an eligible Treasury note or bond is separated through the book-entry system so that each interest payment and the final principal payment becomes its own zero-coupon security. Each piece is a direct obligation of the United States government, so credit risk is negligible, and like other Treasury obligations the interest is exempt from state and local income tax. Because a zero pays no cash before maturity, it carries no reinvestment risk on interim coupons, and it has the longest duration of any bond of a given maturity, so its price is unusually sensitive to changes in interest rates. Her belief about reporting is wrong. The discount accretes as original issue discount, and the holder must include the accreted amount in federal taxable income EACH year even though no cash is received. That phantom income problem is precisely why zero-coupon instruments are usually better held inside a tax-deferred account.

An investor must fund a known $100,000 obligation in exactly 12 years and wants NO reinvestment risk and NO inflation adjustment - just a locked-in accumulation. The cleanest instrument is:

1. A.A 12-year corporate bond with semiannual couponsWrong. Coupons must be reinvested at unknown future rates.
2. B.TIPS maturing in 12 yearsWrong-but-tempting. TIPS add inflation adjustment the investor does not need - and semiannual coupons reintroduce reinvestment.
3. C.A high-dividend stock portfolioWrong. Equity outcomes are unknowable for fixed obligations.
4. D.Treasury STRIPS maturing in 12 yearsCorrect. Zero-coupon structure locks the return to the exact horizon.

Why: STRIPS pay nothing until maturity, eliminating reinvestment risk and matching the horizon exactly; the accreted discount is taxed annually if held in taxable accounts, making tax shelter preferable. Citation: Treasury STRIPS mechanics; OID taxation. Takeaway: known future liability = zero-coupon Treasury matched to the date.