Zero-coupon bonds get their name from the fact that they pay no interest until maturity. This sort of predictable payout makes zeros ideal for a conservative college-savings plan because the maturities can be timed to coincide with the year college bills come due. On top of that, zero-coupon Treasury bonds come with no risk of default.
There is a catch, however. Even though zeros pay no interest each year, at tax time you have to act as if they do. As the "phantom" interest accrues year by year, you must pay income tax on it. This heads off a big tax bill at maturity, but it's a pain in the neck to pay tax today on income you won't see for years. Zero-coupon municipal bonds, which pay tax-free interest, are the surest way around this annoyance. In addition, there may be a way to take advantage of the so-called kiddie tax to minimize the damage from a taxable zero.
The kiddie tax is a provision of the law that says children under the age of 18 must pay tax at their parents' rate on any "unearned" income -- such as interest, dividends or capital gains -- to the extent that it exceeds a certain level, currently $1,700. A child's first $850 of income is tax-free. The next $850 is taxed at the child's rate. Any investment income above $1,700 is taxed at the parent's rate. (These thresholds may change with inflation.)
If the child's rate is 10%, the lowest tax bracket, and the parent's rate is 25%, you have much to gain by shoveling the maximum amount of interest into the child's bracket. And, in fact, the way the IRS says zero-coupon bond interest must be reported works to your advantage.
Say that you or the child's grandparents or all of you together buy your newborn a $10,000 zero paying 4.3% and maturing in 18 years. You pay $4,612 for it. The interest earned by the bond each year isn't 1/18th of the $5,388 difference between the purchase price and the maturity price. Because of compounding, the interest is lower in the early years than it is in the later years. In the first year, $4,612 earning 4.3% compounded semiannually earns about $200. That gets added to your principal, so that in the second year the bond pays 4.3% of $4,812, or $209. The third year you'd earn $218, and so forth.
As you can see, your child can earn a lot of interest before he or she incurs any tax at all. Because of the accelerating nature of the interest payments, a large part of the taxable buildup will occur after the child turns 18 and is taxed on all income at his or her own rate, probably 10%.