What are the basic facts about US Treasury STRIPS, along with pros, cons, who buys them, how they operate, what the tax implications are? Here’s the lowdown on STRIPS investing:
Have you ever thought about investing in STRIPS? If so, you probably have at least a basic idea about what government-backed securities are and how they work.
The acronym’s letters stand for “Separate Trading of Registered Interest and Principal Securities.” Still, when you purchase them through a broker (individuals can’t buy them directly), you’ll notice that they’re just called “STRIPS” for short.
STRIPS: The Basics
STRIPS are the separate interest coupons that were once attached to long-term bonds with maturities of 10 years or more. When you buy one, you’re not purchasing the bond but just the coupon.
Then, semi-annually, you receive the interest payment due on the original bond. So, in a way, STRIPS operate like zero-coupon bonds because investors buy them at a discount from the face amount of total interest.
Another critical characteristic of these federal-government-backed instruments is that you can’t buy them directly from the US Treasury but must go through a broker or banking institution.
STRIPS come with a unique set of advantages and disadvantages and a relatively unique form of tax treatment. To gain a complete understanding, it’s best to begin by assessing the good and bad points of STRIPS.
Pros of Treasury STRIPS
Very few STRIPS are inflation-adjusted, so the interest payout amounts are exact, known, and fully guaranteed by the US government. Therefore, for investors who want to have a specific amount of money available at a precise time in the future, STRIPS are ideal.
Pricing is 100 percent transparent, and you can get a full menu of what maturities and original bond amounts are available from your broker, who will charge a small fee for doing the transaction.
Otherwise, STRIPS are a low-cost way to park long-term investment capital. You’ll never be in the dark about what the payout is or when it is going to occur. Unlike stocks, you’ll never have to stay up on economic and financial news to find out how your STRIPS are doing. Payouts are static and assured.
Cons Treasury STRIPS
As is the case with every type of investment under the sun, STRIPS have their downside. As well, there are certain groups of investors who should not even consider buying them.
For instance, if you miscalculate your need for cash, there’s a chance you might have to sell a STRIPS before it matures. In that case, you stand to lose out for two reasons. First, the secondary STRIPS markets is not always as active as traditional securities and bond markets.
So, you could face a problem of liquidity when you decide to sell early. Second, early sales (before the STRIPS mature) could trigger a tax event in the form of capital gains or losses. That means additional tax figuring and potentially higher tax bills.
Finally, compared to stocks, forex, and many other traditional investment vehicles, STRIPS don’t come with an attractive ROI (return on investment). So consider all your options before locking money into these relatively long-term bond hybrids that are almost the polar opposite of corporate stocks.
What Types of People Purchase STRIPS?
Investors of all kinds can use STRIPS to diversify a portfolio. But as stand-alone instruments, STRIPS are best-suited for people who want to plan for successive payouts every six months or in a lump sum at some time in the future. It’s important to realize that most STRIPS owners use a “ladder” approach, in which they buy the instruments at successive maturity dates, six months apart.
For people who are about a decade away from retirement, laddering can be a smart way to augment a standard pension or IRA. Likewise, you can hold STRIPS in an IRA to simplify and magnify the value of the payouts.
What About Taxes?
Owners of these instruments must pay tax on the accrued interest each year, a process that’s simplified with the issuance of an official form from your brokerage. However, as long as you pay the interest each year, there’s no big, one-time tax bill at maturity.
It’s possible to avert the paperwork of annual tax filing on STRIPS by simply holding them in either a traditional or ROTH IRA. Then, at maturity, you’ll pay your ordinary income tax rate on the total amount of accrued interest if you own a traditional IRA.
Keeping STRIPS in a ROTH IRA has the double advantage of using after-tax money to purchase them and never having to worry about annual interest reporting or ever paying on the accumulated interest at maturity.