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Coupon, Face Value, Maturity, YTM

Original Issue Discount (OID)

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Original Issue Discount (OID)

Zero-coupon and low-coupon bonds generate tax liability before maturity. Know how to calculate the accrued OID.

Key takeaways​

  • OID is the difference between face value and issue price; the issuer is essentially bundling a loan with an implicit yield
  • Accrued OID is taxed as ordinary income annually, even if you receive no cash until maturity
  • The IRS's constant-yield method calculates annual OID accrual; your brokerage reports it on Form 1099-OID
  • Zero-coupon bonds are extreme OID cases: all return comes from price appreciation, all taxed as phantom income
  • Holding OID bonds in retirement accounts (Roth IRA, 401k) avoids the phantom income tax burden
  • OID bonds are attractive for non-taxable accounts and for taxable accounts with low current income

What is OID?​

When a bond is issued at a price below its face value, the difference is Original Issue Discount (OID). The issuer is selling you a bond that will pay you a lump sum at maturity for less upfront cash.

Example: A corporation issues a 5-year bond with no coupons (a zero-coupon bond) for $800, with $1,000 face value. The OID is $1,000 − $800 = $200. The bond will compound implicitly at a rate that turns $800 into $1,000 over 5 years.

Another example: An issuer issues a 10-year bond with a 2% coupon (well below market rates) for $900 (below par). The bond will pay 2% coupons plus return $1,000 principal. The OID is $900 − $1,000 = not directly calculated (it's negative, or there's no OID), but this is a market-discount bond instead.

The IRS distinguishes between:

  1. Original Issue Discount: OID was created at issuance (bond sold below par by the issuer).
  2. Market Discount: the bond was bought at a discount in the secondary market after issuance.

Different tax rules apply. We'll focus on OID.

The phantom income problem​

Here's the key issue: if you buy a zero-coupon bond for $800 and maturity is $1,000, you gain $200 over 5 years. That $200 is considered income for tax purposes. But you don't receive the $200 in cash until maturity.

The IRS doesn't allow you to defer the tax. Instead, you must declare the accrued OID as income annually, even though you're not receiving cash.

Over 5 years, you declare roughly $40 per year as income (the amount derived from the constant-yield method, explained below). If you're in the 37% tax bracket, you owe ~$14.80 per year in taxes ($40 × 0.37), for a total of ~$74 over 5 years. At maturity, you receive $200 in cash, minus the $74 in taxes you've already paid, leaving $126 after-tax gain.

Constant-yield method (tax calculation)​

The IRS requires you to calculate annual OID accrual using the constant-yield method. This is more precise than dividing OID evenly across years.

Formula:

Annual OID accrual = adjusted issue price × yield − coupon paid

Where:

  • Adjusted issue price: starts at the issue price, increases each year by accrued OID.
  • Yield: the bond's effective yield at issuance.

Example: A 5-year zero-coupon bond issued for $800, face value $1,000.

  • Yield: find the rate that turns $800 into $1,000 in 5 years. Using a calculator: ~4.565% annualized.
  • Year 1: adjusted issue price = $800. OID accrual = $800 × 0.04565 = $36.52.
  • Year 2: adjusted issue price = $800 + $36.52 = $836.52. OID accrual = $836.52 × 0.04565 = $38.21.
  • Year 3: adjusted issue price = $836.52 + $38.21 = $874.73. OID accrual = $874.73 × 0.04565 = $39.92.
  • And so on.

Notice the accrual is front-loaded (increases each year) because you're compounding.

Your brokerage calculates this for you and reports it on Form 1099-OID at year-end.

Market discount vs. OID​

If you buy a bond in the secondary market at a discount (not from the issuer), it's market discount, not OID. Tax rules differ.

Example: You buy a 5-year bond in 2025 for $900. Face value $1,000. This is market discount because the issuer did not issue it at $900; the price fell in the secondary market.

For market-discount bonds purchased after 1993, you can elect to defer the discount gain until maturity (clean), or accrue it annually (similar to OID). Without the election, the gain is taxed as a capital gain when you sell or at maturity.

This is simpler than OID (capital gain rate, not ordinary income rate), but the IRS allows an election to accrue. Check your specific situation and tax laws.

Zero-coupon bonds: extreme OID​

Zero-coupon bonds (issued with 0% coupon) are the extreme case of OID. All return comes from the discount.

Example: A Treasury zero-coupon bond (STRIPS) issued for $500, maturity $1,000 in 10 years.

  • All-in OID: $500.
  • Annual accrual: about $47–$52 per year (compounding).
  • You owe tax on ~$47–$52 annually, even though you receive no cash.
  • At maturity, you get $1,000 in cash, but you've already paid 10 years of phantom income tax.

This makes STRIPS unattractive in taxable accounts. They're popular in retirement accounts (Roth IRA, 401k, 529 college savings plans) where the phantom income tax is avoided.

Low-coupon bonds and OID​

A bond issued with a coupon below the applicable federal rate (a rate set by the IRS for OID purposes, currently around 3–5% depending on maturity) is deemed to have OID.

Example: A 10-year corporate bond issued with a 1% coupon when the applicable federal rate is 3.5%.

  • Issue price: $800 (below par).
  • Face value: $1,000.
  • Coupon: 1% annually ($10 per year).
  • OID: $200.
  • Annual accrual (via constant-yield): roughly $22–$25 per year (using the yield-to-maturity as the constant yield).
  • Each year, you declare the $10 coupon plus the $22–$25 OID accrual as ordinary income (roughly $32–$35 total), even though you only receive $10 in cash.

The phantom income ($22–$25) is where the tax hit comes from.

Using OID in retirement accounts​

The tax burden of OID makes these bonds perfect for retirement accounts:

  1. Roth IRA: Put zero-coupon bonds in a Roth. The annual phantom income (accrued OID) is not taxable because Roths are tax-free. At maturity, you withdraw the full face value, and all growth is tax-free.

  2. Traditional 401(k): Similarly, OID accruals are not immediately taxable. Withdrawals in retirement are taxed as ordinary income, but you can defer the tax burden for decades.

  3. 529 college savings plans: Education savings accounts can hold zero-coupon bonds to fund college expenses in 18 years, with no current tax.

This is a major tax-planning win: use OID bonds to defer and reduce current-year tax burden by holding them in tax-sheltered accounts.

Calculating your after-tax return on OID bonds​

Example: A 5-year zero-coupon bond bought for $800, face value $1,000, in a taxable account.

  • Annual OID accrual: ~$36–$40 per year (varies with compound method).
  • Your tax bracket: 35%.
  • Annual tax: ~$12.60–$14 per year.
  • Total tax over 5 years: ~$63–$70.
  • After-tax gain: $200 − $70 = $130.
  • After-tax return: about 3.3% annualized.

But if you held the same bond in a Roth IRA:

  • No annual tax.
  • Gain at maturity: $200 fully captured.
  • After-tax return: about 4.57% annualized (same as pre-tax because it's tax-free growth).

The difference: ~1.2% annual return, substantial over 5 years. This is why OID bonds are best in Roths or traditional 401ks.

Reporting OID on your tax return​

Your brokerage sends you Form 1099-OID at year-end if you hold OID bonds. The form shows:

  • Box 1: OID accrued during the year.
  • Box 2: Early withdrawal penalty (applicable to savings bonds, not typical bonds).

Report the Box 1 amount as ordinary income on your tax return (Schedule B for federal income tax, Part II).

If you bought the bond in the secondary market after issuance (market discount, not OID), you'll receive a 1099-INT instead, and the tax treatment is different.

Flowchart: OID bond decision​

Example: buying STRIPS in a Roth IRA​

Scenario: You have $50,000 in a Roth IRA and want to invest for a child's college in 18 years (now age 1, college at age 19).

  • Buy Treasury STRIPS maturing in 18 years for $12,500.
  • Face value: $50,000.
  • Annual OID accrual: ~$133 per year.
  • In a taxable account: you'd owe ~$46 per year in taxes (35% bracket), or ~$828 over 18 years.
  • In a Roth: $0 in taxes. The $50,000 grows fully tax-free.

The STRIPS in a Roth is a no-brainer for this goal. The same STRIPS in a taxable account would be unattractive due to phantom income tax.

Summary: OID is a tax issue, not an investment issue​

OID bonds are not inherently bad; they're bad in taxable accounts because of phantom income tax. The same bonds are excellent in retirement accounts.

If you're buying an OID bond for a taxable account, make sure the yield compensates for the phantom income tax drag. Usually, it doesn't — which is why sophisticated investors hold OID bonds in Roths and 401ks.

Next​

We've explored yields, spreads, taxes, and discounts. Now, how do professional traders and brokers quote bonds? The next article decodes bond quotes: bid-ask spreads, quotes in 32nds, and how to read a Bloomberg or Tradeweb screen.