Wouldn't it be wonderful if there were an investment that allows you to plan ahead for predictable amounts of money that you'll need later—to pay college expenses or fund your retirement, for instance?

Say hello to zero coupon bonds! With zero coupon bonds, you decide when you want them to mature by purchasing specific maturity dates.

Dolan Smart Money Move: The price of zeros, as they're called, is extremely sensitive to changing interest rates. As a result, zeros are among the most volatile fixed income investments around. That's why we recommend buying zeros only as investments you will hold until maturity, when your return is guaranteed. If you buy zeros that mature in five years and you need to tap your money in three years, you could lose some of your investment.

Zero coupon bonds don't pay you any current income. You make money on zero coupon bonds by buying them from a broker at a deep discount (paying a whole lot less than the bond's $1,000 face value). You then get $1,000 when the bond matures. The difference between what you paid for the bond and its $1,000 face value is the amount of "interest" you earn.

What's the catch?

Well, even though you don't get handed the interest each month—as you do at your bank—the interest is still taxable to you in the year it's earned. That's one reason we like zero coupon bonds as an investment for tax-deferred retirement accounts. In an IRA or Keogh, you don't have to pay yearly taxes and you get the full benefit of the long-term compounding of your zeros.

We also like using Treasury zeros to fund your child's college education, because you know exactly how much you will have and when. But don't forget the taxes that will come due each year. If taxes will be a big problem, buy highly rated municipal zeros.

The best strategy for buying zeros for college? Buy zeros that will mature each year, just before your child's college tuition bill comes in!

The Costs of a $1,000 Zero Coupon Bond

To help you see what we're talking about, we've put together the following table. If you purchase a zero coupon bond with a $1,000 face value and the following years to maturity, here's what you would pay for the bond at different yields:

Related Links:

• Best Ways to Save for College
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