Zero-Coupon Bonds: Target Date Funding, Reinvestment Risk, and Phantom Income
Parents wish to ensure they have exactly $100,000 available in 14 years to fund their 4-year-old child's college tuition. They seek an investment with zero reinvestment risk that locks in a guaranteed lump sum on a specific future target date. Which security is most suitable, and what tax consideration must be disclosed?
Zero-coupon bonds (like Treasury STRIPS) eliminate reinvestment risk and guarantee an exact future lump sum on a target date, but accreted interest is taxable annually ('phantom tax').
Complete Analysis & Legal Rationale
Zero-coupon bonds (such as Treasury STRIPS) do not pay periodic cash interest; they are purchased at a deep discount and mature at face value. Because there are no periodic coupon cash flows to reinvest, zero-coupon bonds completely ELIMINATE reinvestment risk, guaranteeing a predictable future lump sum on a precise date. However, IRS rules require annual accretion of the discount, meaning investors must pay federal income tax annually on this accreted income ('phantom income'), making zero-coupon Treasuries best suited for tax-sheltered accounts like 529 plans or IRAs.
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
Zero-coupon bonds (like Treasury STRIPS) eliminate reinvestment risk and guarantee an exact future lump sum on a target date, but accreted interest is taxable annually ('phantom tax').
Fails to adhere to suitability standards regarding B.
Fails to adhere to suitability standards regarding C.
Fails to adhere to suitability standards regarding D.
Official Standard: Zero-coupon bonds (such as Treasury STRIPS) do not pay periodic cash interest; they are purchased at a deep discount and mature at face value. Because