What is a significant tax implication of zero-coupon bonds?

The significant tax implication of zero-coupon bonds is that investors pay taxes on accrued interest each year. This is primarily due to the nature of zero-coupon bonds, which do not provide periodic interest payments like traditional bonds. Instead, they are issued at a discount to their face value and pay the face value at maturity.

The IRS requires that the imputed interest, known as "accrued interest," be reported as income each year, even though the investor does not actually receive any cash until maturity. This means that investors are taxed annually on the interest that accumulates, leading to a situation where they pay taxes on income that they do not realize until the bond matures. This unique tax treatment makes it crucial for investors in zero-coupon bonds to plan for the potential tax liability each year, despite not receiving any cash payments.

In contrast, other options related to payment and tax timing do not accurately reflect the mechanics of zero-coupon bonds and how they are taxed under IRS rules.