Chapter 3

Question 1

Individual Account Features: There are three primary types of trading authority that the exam might ask about: limited, full, and discretionary. Describe the differences between them

Answer 1

Limited Trading Authority: Can authorize trades but not make withdraws

Full Trading Authority: Trades & Withdrawals

Discretionary Authority: Given to advisors, to choose on behalf without asking for permission

Question 2

If a person who has one the following, dies, what benefits does the other one get?
joint tenants with rights of survivorship account (JTWROS or JTROS) & joint tenants in common account (JTIC),

Answer 2

Joint tenants with rights of survivorship account (JTWROS or JTROS): The other person on the acct gets the assets automatically

Joint tenants in common account (JTIC): The other person only gets their percentage, the deceased percentage goes to their estate - usually probate issues

Question 3

Is an IRA under ERISA rules?

Answer 3

Nope

Question 4

Business Structures: Sole Proprietorship, pros and cons

Answer 4

Pros: easy to do taxes, easy to set up
Cons: full liability, harder to get loans then other business structures

Question 5

Business Structures: Sole Proprietorship, Sustainability/Ideal investments?

Answer 5

They need to be liquid, risky investments not appropriate,
Ideal: Large-cap stocks that pay dividends / Securities with high dividend payout ratios

Question 6

Can limited partners in a Limited Partnership (LP) vote on some or all of the following: dissolving the partnership, suing the general partner, and inspecting the partnership’s records.

Answer 6

All

Question 7

Which of the following would be most appropriate for a sole proprietor?

A. Hedge fund
B. B shares of a balanced mutual fund
C. Small-cap equity securities
D. Securities with high dividend payout ratios

Answer 7

Answer: D. Sole proprietors need liquidity in their portfolio to deal with unexpected expenses. Hedge funds are inappropriate, because they often require a minimum two-year investment. B shares are unsuitable, because the back-end sales charge goes away the longer the portfolio is held. While small-cap stocks may show a greater return in the long run, they are more volatile and may show negative returns in the short-term. Of the options, this leaves securities with high dividend payout ratios.

Question 8

How do LPs often raise money and please explain how they work

Answer 8

Often raise through Recourse Notes, something a LP signs that say they will that a certain amount of debt, basically agrees the creditor can come after them for that debt

Question 9

What is the difference between a C corp and an S corp?

Answer 9

C Corps - Are fkn everywhere, unlimited members, taxed twice (double taxation), easiest way to raise money, multiple classes of stock

S Corps - 100 or less investors, “pass through” taxes, must be US Citizens, other corps can’t be shareholders, no more than 1 class of stock

Question 10

What investments are recommended for Estate Accounts and why?

Answer 10

Because the assets need to be kept in a safe account where they can be easily accessed, any investments need to be safe and liquid. For this reason:

money market investments, such as T-bills, CDs, and other short-term debt securities are appropriate recommendations.

Question 11

Additionally, a married person can pass their lifetime gift tax exclusion to their spouse for estate tax purposes. When this occurs, the surviving spouse receives any unused portion of their spouse’s lifetime exclusion. Thus, a surviving married person could receive a lifetime exclusion of up to $24.12 million (2 × $12.06 million). This ability to pass on your unused lifetime exclusion to your spouse is called ______.

Answer 11

Portability

Question 12

Debbie dies suddenly. She has a sizable estate of $40.2 million. Her will stipulates that she will leave her favorite charity $5 million. In the last two years, she has made sizable gifts to her children and grandchildren. In fact, she has given a total of $2 million above her annual $16,000 gift exclusions to her children and grandchildren. Her husband died three years earlier and he never used his lifetime exclusion. Assuming funeral and administrative costs totaled $200,000, how much will be subject to taxation?

Answer 12

Answer: $12.88 million. Take $40.2 million – $5 million – $200,000 = $35 million for the value of her estate. Debbie’s lifetime exclusion would be $12.06 million – $2 million (already gifted) = $10.6 million. She also receives her husband’s lifetime exclusion, which is $12.06 million. So the value that is subject to estate taxes would be: $35 million – $10.06 million – $12.06 million = $12.88 million.

Question 13

Who can initiate transactions, control the transfer of funds and disbursements, etc., from a trust?
A Trustor
B Trustee
C Beneficiary

Answer 13

B) Trustee

Although the Trustor (the one who opened the acct and puts money in it) usually assigns themselves the trustee

Question 14

True or False. Any income earned within a trust is subject to annual taxation.

Answer 14

True

The trusts themselves do not pay taxes on this distributed income. Trusts do pay taxes on income they do not distribute to the beneficiaries at very high rates.

Question 15

Living versus testamentary trusts.

Answer 15

Living is a trust created when a person is alive, testamentary trust is created upon the death of a person

Question 16

Simple vs Complex Trusts

Answer 16

Simple: Distributes all the income to the beneficiaries the year it is earned, can’t do anything fancy like give to charity

Complex: Can sell assets and give to charity ; does not distribute all its earned income to beneficiaries

Question 17

Charitable Trust - what is the difference between a lead trust and a remainder trust?

Answer 17

Lead Trust - Charity paid first
Remainder Trust - Beneficiaries paid first, anything remaining is given to charity

Question 18

True or False. Charitable remainder trusts are irrevocable.

Answer 18

True

Question 19

Who pays the capital gains from a trust, the trust or a beneficiary?

Answer 19

The Trust
Unlike interest and dividend income, however, capital gains are usually taxed to the trust rather than the beneficiaries.

Question 20

A _____ account refers to an arrangement where one fee is charged by a broker-dealer or investment adviser for all its services. These services might include the costs of trading, portfolio management, investment advice, asset allocation, and custody of assets.

Answer 20

Wrap

Question 21

Client Profile: Preservation of Capital, recommendations

Answer 21

FDIC-insured bank CDs, U.S. Treasury securities, and money market mutual funds would all be acceptable recommendations. Any type of investment that puts the principal at risk is not acceptable to this type of investor.

Question 22

Client Profile: Current Income, recommendations

Answer 22

Current income investors are often retirees or individuals who need the income to meet their living expenses. Portfolios that need to generate regular and stable cash returns may include a combination of fixed-income securities, such as U.S. Treasuries, agency bonds, municipal bonds, and corporate bonds, as well as equities that emphasize income over growth, such as preferred stocks, REITs, and dividend-paying stocks.

Question 23

If a client is in a high tax bracket and values current income, ______ bonds are an excellent choice, because the interest earned on them is often not subject to any taxation.

Answer 23

municipal

Question 24

Client Profile: Capital Growth

Question 25

Your niece has just graduated from college with a double major in math and computer science. After accepting a job offer from a Silicon Valley company, she comes to you for advice about investing her signing bonus. She is a smart young woman and she says she wants to start saving for retirement. You tell her that because a bonus is considered earned income, she can use the money to open an IRA. Which of the following asset allocations would be best for the new IRA of your 22-year-old niece:

A. 60% equities, 20% bonds, 20% cash

B. 40% equities, 40% Treasury securities, 20% gold

C. 50% equities, 30% REITs, 20% bonds

D. 80% equities, 20% bonds

Answer 25

Answer: D. Even though equities (stocks) are more volatile than other asset classes, over long periods, they offer the highest returns. Since your niece is just 22 and since she wants to start saving for retirement, the choice with the highest allocation to equities is the best one for her.

Question 26

What is the most important suitability information for a client with a disabled child? You may have to choose between risk tolerance, time horizon, and the client’s current ratio

Answer 26

The client’s current ratio (short-term assets/short-term liabilities) is the best choice, because it will tell how much greater a client’s current assets are over their current liabilities. The higher the current ratio, the better prepared the client is.

Question 27

Name investments that are more appropriate with someone who has a long investment horizon.

Answer 27

Annuities, limited partnerships, hedge funds, and B shares from mutual funds are all less liquid and might be appropriate for an investor with a long investment horizon.

Growth stocks, small-cap funds, and emerging market funds are more aggressive equity choices and might be appropriate for an investor with a long investment horizon.

Question 28

Where can you find an individuals net worth? Cash Flow/Income Statement or Balance Sheet?

Answer 28

Balance Sheet
The bottom line of the balance sheet is a client’s net worth, or their assets minus their debts (liabilities)

Question 29

Investment recommendation for someone with moderate risk

Answer 29

Moderate risk tolerance investors tend to do well with a diversified portfolio of stocks, perhaps focusing on blue chip stocks, and bonds from large companies and established markets. Lower cost ETFs and no-load index funds may also be a good option.

Question 30

Investment recommendation for someone with conservative risk

Answer 30

These clients are best directed toward income-producing investments, such as high-grade corporate, municipal, state, or federal bonds.

Question 31

Investment recommendation for someone with aggressive risk

Answer 31

Aggressive risk tolerance investors may invest in stocks from smaller companies and less established international companies, as well as lower grade bonds that offer higher yields.

Question 32

The underlying philosophy of modern portfolio theory is ________.

Answer 32

diversification

Question 33

CAPM - If a stock has a beta of “0,” it means what?

Answer 33

It has no relation to the movement of the market

“it means that there is no relationship between how its price fluctuates and the fluctuation of the market”

Question 34

A $10 stock has a beta of 2.0. The expected return in the market, based on its recent performance is 7%, and the risk-free rate as measured by the Treasury bill rate is 2%. Using CAPM, we can calculate the expected return for the security

Answer 34

12%

2% + (2.0 × (7% – 2%)) = 12%.

Question 35

A $10 stock has a beta of 0.5. The expected return in the market is 7% and the risk-free rate 2%. What is the expected return for the security?

Answer 35

4.5%

2% + (0.5 × (7% – 2%)) = 4.5%

Question 36

ABC Company has a beta of -0.5, the market is expected to return 8% this coming year, and investors can earn 2% risk-free in short-term U.S. Treasury bills.

Answer 36

-1%

2% + (-0.5 × (8% – 2%)) = -1%

Question 37

CAPM - The difference between a security’s actual return and its expected return is known as the stock’s _____

actual return – expected return = _____

Answer 37

Alpha

Question 38

There are three forms of the efficient market hypothesis, name them

Answer 38

strong, semi-strong, and weak

Question 39

Efficient Market Hypothesis- the strong form of the theory states what?

Answer 39

All information, private and public, is reflected in the market price of the security.

Question 40

Efficient Market Hypothesis- the semi-strong form of the theory states what?

Answer 40

That PUBLIC information is wholly and immediately reflected in the price of the security.

Thus, anyone with insider knowledge can beat the system

Question 41

Efficient Market Hypothesis- the weak form of the theory states what?

Answer 41

That movements can be predicted by using fundamental analysis
Weak form efficient market hypothesis is the version that most lends itself to an active management style.

Question 42

Portfolio Management Styles and Strategies / Strategic Asset Allocation - Explain

Answer 42

It’s more closely associated to a BUY and HOLD strategy, optimum portfolio mix to maximize returns,
needs to be rebalanced periodically

PASSIVE MANAGEMENT

• 60% stocks
• 20% government bonds
• 10% corporate bonds
• 10% cash

Question 43

Portfolio Management Styles and Strategies / Tactical Asset Allocation - Explain

Answer 43

it attempts to TIME the market, moving in and out of asset classes and sectors based on certain indicators of the direction of the market

ACTIVE MANAGEMENT

Uses technical and fundamental analysis

Question 44

How cab a fixed-income investor can save for a target date and reduce interest rate risk?

Answer 44

Laddering

Laddering is a strategy whereby a fixed-income investor buys multiple bonds or CDs at different maturities in order to avoid being locked into a single interest rate and a single maturity.

Question 45

What us better ti receive, a tax deduction or a tax credit?

Answer 45

Tax Credit

A deduction is an amount that you can subtract off your taxable income, while a tax credit is an amount you can subtract off your tax bill. Typically, a tax credit is more beneficial to the taxpayer than a tax deduction. For example, imagine an investor has $100,000 of taxable income and a 25% tax rate, and the choice between a $5,000 tax deduction and a $5,000 tax credit. If he took the $5,000 deduction, his taxable income would be reduced to $95,000 and his tax bill would be 25% of that amount, $23,750. A tax credit can be subtracted off your tax bill, dollar for dollar. So, 25% of $100,000 is $25,000, and the $5,000 can be subtracted from that, bringing the tax bill down to $20,000. Hence, the tax credit is more beneficial to the taxpayer than the tax deduction.

Question 46

If an investor bought a security on January 5, 2022, and sold it on January 5, 2023, would it be considered a short-term gain/loss or long-term gain/loss?

Answer 46

short-term gain/loss
According to the IRS, the holding period clock begins the day after the investment was purchased and ends on the day the investment was sold.

Question 47

True of False. The cost basis of inherited securities is the value of the security on the date of the donor’s death.

Answer 47

True

Question 48

The IRS permits ____ and _____ investors to use the average cost basis

Answer 48

Mutual Funds, DRIP (dividend reinvestment plan)

Question 49

In the event that a taxpayer dies and his heirs inherit his securities positions, the tax laws give the new owners of the securities a huge break. No matter what the original owner paid for the securities, the people inheriting the securities get to claim the price of those securities on what date? as the securities’ new tax basis. This is referred to as a _______. In addition, even if your client immediately sold the stock, any profit would be considered a [short-term/long-term gain].

Answer 49

deceased person’s date of death
stepped-up basis
long-term gain

For example, if a rich uncle leaves one of your clients 10,000 shares that he bought at a penny a share, your client’s tax basis is not the uncle’s original price of one penny per share (which would result in huge capital gains taxes when sold). Your client’s tax basis is actually the price of the stock on the day the uncle died. If the stock was trading at $100 a share on the day the uncle died, that is your client’s starting point for calculating profit or loss, not the penny a share the uncle paid for it. In addition, even if your client immediately sold the stock, any profit would be considered a long-term gain.

Question 50

An investor wanting to reduce possible exposure to the AMT tax might consider all of the following strategies except:

A. Contributing the maximum to a 401(k) plan
B. Investing in private activity municipal bonds
C. Offsetting capital gains with capital losses
D. Living in a low-tax state and never having children or any other dependents

Answer 50

Answer: B. Anything that reduces your adjusted gross income (AGI) reduces potential exposure to the alternative minimum tax. Thus maximizing contributions to an employer-sponsored retirement plan, such as a 401(k) plan, is a smart move. Likewise, offsetting capital gains with capital losses will keep your AGI down and, thus, reduce AMT exposure. Since the AMT hits taxpayers in high-tax locales the hardest (under the AMT, state and local income and property taxes are not deductible), living in a low-tax state could minimize your AMT exposure, as would not having children, since without them, you would not lose the dependent deductions under the AMT calculation. However, investing in private activity municipal bonds would increase potential AMT tax, since unlike most municipal bonds, interest from private activity bonds is not tax-free under the AMT

Were the exam to ask you to select which investment choice would help a higher income taxpayer avoid AMT exposure, you would want to pick anything that lowers adjusted gross income (AGI), because the lower your AGI, the lower your AMT. Contributions to employer-sponsored retirement plans such as 401(k), 457, 403(b), and SIMPLE IRA plans, as well as a traditional, deductible IRA, and health savings accounts, all reduce AGI and, thus, reduce potential AMT consequences. Selling investment losers held in taxable accounts and using capital losses to offset capital gains also reduces AGI and, thus, potential AMT. A taxpayer with potential AMT exposure might want to defer any securities sales that would result in gains into a future year when the taxpayer might not be exposed to the AMT.

Question 51

Estate taxes must be paid within ____ months of the date of death

Answer 51

nine

Question 52

Which of the following wouldn’t be a reason to have an investment policy statement for a retirement plan?

A. It limits an employer’s liability as a fiduciary.

B. It serves as a guide for what to invest in, as well as a means of assessing how well the fiduciary has met the policy’s investment goals.

C. It is a requirement to be a qualified retirement plan.

D. It serves as a guiding document outlining how many of the ERISA Section 404(c) requirements are met.

Answer 52

Answer: C. IPSs limit an employer’s liability as a fiduciary. Companies that have operated within the parameters set by their IPSs are generally spared punitive action by regulators if losses due to investment performance occur within the plan. An IPS is a guiding document outlining how many of the ERISA Section 404(c) requirements are met. An IPS also serves as a guide for what to invest in, as well as a means of assessing how well the fiduciary has met the policy’s investment goals. The IRS does not require that qualified plans have an investment policy statement. Although the provisions set by ERISA do not require a company to have an IPS, they do recommend it.

Question 53

IRA SEP plans vs. IRA SIMPLE plans
Hint: Small Business Retirement Plans

Answer 53

SEP: Under this type of plan, the business owner can make pre-tax contributions into IRA accounts set up for eligible employees and also for herself if the owner is self-employed. The plan allows employers to skip contributions in years when business is bad, but if the owner makes a contribution for herself she must also make contributions for her employees. When contributions are made, they must be made for all participants who actually performed work during the year for which the contributions are made, including those over 72 years of age (the latter feature is unique to the SEP plan). Contributions for all participants generally must be uniform; for example, they must represent the same percentage of hourly wage for each participant.

Simple: The SIMPLE IRA plan is a retirement plan for businesses with no more than 100 employees. With a SIMPLE IRA, the employee may make pre-tax contributions to the plan. The employer is required to either match these contributions up to 3% of the employee’s compensation or to contribute 2%, whether the employee makes a contribution or not. All employees who earned more than $5,000 in the preceding year are eligible under this plan. Unlike the SEP plan, however, premature SIMPLE IRA distributions (withdrawals of account funds) will incur a 25% penalty in the first two years the account exists if made before age 59 1/2.

Funding a SIMPLE IRA plan is mandatory no matter what kind of year the business had. Like the SEP plan, SIMPLE IRAs are 100% vested at all times because they are IRAs.

Question 54

There are typically two types of investment approaches followed by participants in college savings plans: age-based and static-choice options. Explain them

Answer 54

Age-based investing, sometimes called target-date investing, involve5s the automatic adjustment of portfolio assets from a higher percentage of equities in the early years to a higher percentage of a lower risk fixed income securities and cash as the student’s college enrollment date approaches. In contrast, with a static-choice option a 529 account portfolio will typically maintain the same asset allocation for the plan’s duration.

Question 55

There are two types of 529 plans: college savings plans and prepaid tuition plans. Explain them.

Question 56

What are some similarities and differences between a 529 Savings Plan and Coverdell Savings Account (CESA)?

Answer 56

Similarities: Both are after-tax dollars and can remove tax free on qualified expenses

Coverdell has max contributions (2k), can’t put more $ past 18yrs and @ 30yrs must be closed.

Question 57

Which is easier to set up, an UGMA/UTMA or a Trust?

Answer 57

UGMA/UTMA

Question 58

True or False. UGMA/UTMA: All gifts are irrevocable and convey an indefeasible title, meaning the donor cannot take back the gift and the minor cannot return it.

Answer 58

True

Question 59

True or False. A 529 college savings plan are considered assets of the minor and are thus counted heavily against need-based financial aid, unlike the assets in UGMA and UTMA accounts.

Answer 59

False

Both UGMA and UTMA accounts are considered assets of the minor and are thus counted heavily against need-based financial aid, unlike the assets in a 529 college savings plan.