Imputed Interest

Imputed. Guessed at. Or presumed, based on x, y, and z. That’s the foundation of an imputed interest rate, and it’s chief cheerleader is the IRS.

Why? Because taxes need to be collected. We have pork to buy for politicians. Come on, people. Get with it.

So...we have a zero coupon bond we bought for $500, which comes due (or pays off) in 10 years. Only, remember: zero coupon bonds don’t pay any interest along the way. They just pay a one-time, end-of-period amount, which includes interest and principal.

The IRS taxes bondholders' imputed interest, based on whatever interest rate is imputed by the terms of the deal.

In this case, remember that rule of 72 thing? So many years to double, divided into 72 and all that? Yeah. So in this case, the money takes 10 years to double: 10 into 72: 7.2% interest rate.

So the IRS would take as an imputed interest 500 bucks times 7.2,which is 36 dollars of taxable imputed interest. If you owned this bond and were living in a 40% marginal tax bracket, even though you got no cash interest from this bond, you’d suffer a cash tax hit of 40 percent of 36, or a bit under 15 bucks each year as you went along.

That's the bad news. The good news is that, when the bond fully came due, you’d have already paid the taxes along the way. And when taxes are already paid, uh, we impute you’ll be a happy camper.