Custom 1A Flashcards
1
Q
What is equivalent Taxable Yield
A
Tax Free Yield/ 100%-Tax Bracket% = Equivalent Taxable Yield
2
Q
What is Equivalent Tax Free Yield
A
Equivalent Tax-Free Yield= Taxable Yield x (100%-Tax Bracket%)
3
Q
What is Price/Earnings ratio? What does it mean? How is it applied?
A
dividing the market value price per share by the company earnings per share P/E = Share Price divided by Earnings Per Share
4
Q
What is Standard Deviation
A
It measures the spread of the distribution of returns compared to the average return.
5
Q
Debt/Equity Ratio
A
Longterm Debt/Total Stockholders Equity
6
Q
What is Sharpe Ratio?
A
Sharpe ratio seeks to measure reward as defined by the risk adjusted rate of return versus volatility as defined by standard deviation.
7
Q
What is sharpe ratio?
A
8
Q
What are some fundamental factors to consider when selecting stocks for the fundamental traders?
A
current products, new products, management, market share, industry outlook
9
Q
What is the difference between a Roth IRA and a Traditional IRA?
A
Roth IRA has backloaded tax benefits, while a traditional IRA has front loaded tax benefits. You can not contribute maximum to both Roth IRA and Traditional IRA.
10
Q
Define Stocks
A
Common is Equity, issued by regular corporations and investment companies
11
Q
Define Bonds
A
Debt Note
12
Q
What is P/E Ratio
A
Market Price of Security/Earnings Per Share
13
Q
Define Dividend Discount Model? Math?
A
14
Q
Define unit trusts
A
1 of 3 types of investment companies defined in the investment company act of 1940. A UIT is organized not as a corporation, but as a trust which issues units (called shares of beneficial interest) representing an undivided interest in a porfolio of securities. UITs can either be fixed or non-fixed. In a fixed UIT, the trust establishes a portfolio that never changes. The porfolio eventually self-liquidates. In a non-fixed UIT, a holding company buys open-end management company (mutual funds) shares. Investors buy units of the holding company.
15
Q
Define mutual funds
A
Commonly used name for an open-end management company that establishes a diversified portfolio of investments that is actively managed, and then continually issues new shares and redeems old shares representing ownership in the porfolio
16
Q
Define annuities, what is the different between non-tax qualified and tax qualified annuities?
A
non-qualified annuity is funded with after-tax dollars, meaning you have already paid taxes on the money before it goes into the annuity. Qualified annuity is funded with before tax dollars.
17
Q
Donations, Donation to Charity Gives Deduction Equal
to Current Market Value
A
As a general rule, donations of appreciated property to a charity give the donor a tax
deduction equal to the market value at the donation date. No tax is payable on the
increase in value of the asset as long as it has been held for over 1 year (long term).
This is known as a “stepped up basis,” and the cost basis to the recipient becomes the
current higher market value.
18
Q
Cost Basis Becomes Current Market Value
A
If the appreciated property is held for 1 year or less, tax is due on the increase in value. (donations)
For example, an individual owns stock for a number of years that cost $40 per
share, and is now worth $60 per share. If the stock is donated to a charity, the
tax deduction to that individual is $60 per share. The charity’s cost basis
becomes $60 per share
19
Q
Donations to Anyone Else - No Deduction
A
If donations of securities are made to family members (or to anyone other than a
charitable organization), the cost basis to the recipient is the original cost basis of the
donor, as of the date of the gift.
Recipient’s Cost Basis Is the Same as for Donor
For example, an individual owns stock for a number of years that cost $40 per
share, and is now worth $60 per share. The stock is donated to a custodial
account for this person’s daughter. There is no tax deduction for this individual.
The daughter’s cost basis in that security becomes $40 per share.
Please note that this is considered to be a gift, which is subject to “gift tax” (discussed
following). Also note that the gift tax paid can be used to increase the basis of the
property when it is sold.
20
Q
Inherited Securities Cost Basis Is Fair Market Value at
Date of Death
A
However, if a security is received as the result of an inheritance, the cost basis to the
recipient is the fair market value as of the date of death. The estate is responsible for
paying any “estate tax” liability on this asset (discussed following).
21
Q
Corporate and Trust Income Taxes
A
Corporations, trusts, and estates that invest in securities are treated in a similar
manner to individual investors. However, the tax rates paid are different and generally
higher than individual rates.
Please note that for trusts, there are 2 types of trusts:
Revocable Trust
Where the grantor transfers assets into the trust, but has the right to take them
back at a later date.
Irrevocable Trust
Where the grantor transfers assets into the trust, but does not have the right to
take them back at a later date.
Income in a revocable trust is taxed at the rate of the grantor (if the grantor is an
individual or a couple, then the income is taxed at personal income tax rates -
maximum of 37%).
Income in an irrevocable trust is taxed at the rate for trusts - this is a schedule similar
to that for personal income tax.
22
Q
50% of Dividends Received by Corporation Are Excluded
from Tax
A
A large corporate tax break is the “dividend exclusion.” If a corporation owns less than
20% of another company, 50% of dividends received are excluded from tax. If 20% or
more is owned, the exclusion increases to 65%. Please note that this tax break is not
available to individuals.
Interest earned by corporate investors on corporate and government obligations is
fully taxable. Interest earned on municipal obligations is, generally, not taxed.
23
Q
Estate and Gift Taxes
A
The “concept” of estate and gift taxes is entirely different than that for income taxes.
Income taxes are paid by the person who receives the income. Estate and gift taxes
are paid by the person who has the money, not by the person who receives the
money! The idea is to break down the transfer of inherited wealth in this country,
giving everyone the incentive to work.
24
Q
Tax Paid by Donor, Progressive Tax
A
If a person dies, tax is due on the estate, to be paid by the estate. If a person gives a
gift, tax is due on the gift, to be paid by the donor - not the recipient. Estate and gift
taxes are progressive, with the tax rate increasing as the size of the gift or estate
increases to a maximum rate of 40% in 2023. The value of the gift or estate is set at
the date the gift is given or the date of death.
25
Gift Tax Exclusion - per Person Indexed for Inflation
Annually, $17,000 in 2023
Gifts above a set amount per person per year can be given without incurring gift tax.
Any gifts given above the annual amount are taxable; but can be included in the
estate tax exemption discussed following. The gift tax exclusion is indexed for inflation
annually, and the amount has been increased to $17,000 for 2023
26
Recipient of Gift Assumes Cost Basis of Donor and
Donor's Holding Period
When a gift is given, the recipient assumes the cost basis of the donor and also
assumes the donor's holding period.
For example, assume that a mother buys a piece of jewelry for $2,000. Years
later, she gifts it to her daughter when it is worth $3,000. The daughter sells the
piece of jewelry for $4,000. The daughter has a taxable capital gain of $2,000
($4,000 sale proceeds versus $2,000 carry-over cost basis).
Also note in the above example that the mother is not subject to gift tax, because the
dollar value is within the annual exclusion amount.
27
Estate Tax Exemption
A certain amount of an estate, adjusted for inflation annually, is excluded from tax. In
2023, the adjusted exemption amount is $12,920,000.
28
Unlimited Marital Exclusion
For married couples, if one spouse dies or gives a gift to the other, there is an unlimited
marital exclusion from gift or estate tax. Such tax is due when the surviving spouse
dies. Thus, if a husband and wife have individual assets of $12,920,000 each ($25,840,000
total) and the husband dies, the $12,920,000 estate of the husband is not subject to
tax until the wife dies.
29
Unified Credit
The way that the exclusion amount from estate (and gift) tax is handled in the tax
code is that a lifetime "unified tax credit" is given to any estate value above
$12,920,000 (in 2023) and any annual gifts given above $17,000 per person (in 2023).
Once the unified credit is exhausted, the gift or estate tax becomes due on the excess
amount
30
Charitable Contributions Reduce Taxable Estate
The taxable estate is reduced by any charitable deductions made by the decedent to a
qualifying charity and also by any mortgages and debt of the decedent. Therefore, if
an individual's estate is likely to be more than $12,920,000 (in 2023), the individual
can make charitable contributions to avoid the estate tax.
31
Permitted Deductions to Calculate Taxable Estate
When calculating the value of the "taxable estate" (one valued over $12,920,000 in
2023), the IRS allows the executor to deduct:
Funeral expenses;
Administrative expenses;
Legal fees;
Claims against the estate such as unpaid bills;
Mortgages against estate-owned property;
Assets donated to charities from the estate (covered previously); and
Any estate tax liability owed to the State.
Thus, only the "net estate" (after all these deductions) of more than $12,920,000 in
2023 is taxable.
32
Cost Basis of Inherited Asset Is Value at Date of Death
When assets are inherited, the tax basis in the asset is the value at date of death. If
the asset has appreciated, this is called a "stepped-up" basis. When an inherited
asset is sold, any gain or loss is always treated as long term.
For example, assume that a mother buys a piece of jewelry in January for
$2,000. The mother dies one month later, in February, and she wills it to her
daughter when it is worth $3,000. The daughter sells the piece of jewelry in June
of the same year for $4,000. She has a long term capital gain of $1,000 ($4,000
sale proceeds versus $3,000 "stepped-up" cost basis). Note that even though the
jewelry was held for less than 1 year before it was sold, the gain is still taxed as
long term.
33
Securities Valued at Date of Death
For estate tax purposes, any securities positions owned by the decedent are valued as
of the date of death. If there is any tax due (after taking into account the exclusion
amount), the payment must be made by 9 months after the date of death.
34
Alternate Valuation Date for Securities
For taxable estates (meaning those with over $12,920,000 of assets in 2023), the tax
code permits the estate to elect an "alternate valuation date" for securities positions,
which is set at 6 months after death. The executor would use this if the securities
positions fell in value in the 6 months after death, to reduce estate tax liability.A tax strategy that was tried over the years to reduce estate taxes was to leave
assets directly to persons two or more generations younger than the donor.
For example, a donor could set up a trust for his adult child, leaving only the income
from the trust to that adult child and then when the adult child died, the principal
would go to a grandchild. This strategy could result in a "skip" of estate tax, since it
would only be paid by the donor on death; and not when the child died and the trust
transferred its assets to the grandchild
35
Generation Skipping Tax (GST)
To avoid this, the tax code has the "GST" - Generation Skipping Tax. If a gift or
transfer is made to a person 2 or more generations younger, the GST is applied to the
"skip" at the maximum estate tax rate (with the estate tax exclusion amount reducing
the amount of tax due).
36
Alternative Minimum Tax (AMT)
In theory, all of the tax deductions we have covered can be used by a taxpayer to
completely offset his passive income. If this were his only source of income, he would
have no tax liability! Congress strikes again because it feels that everyone should pay
some tax.
Under the tax law, the taxpayer must compute the "alternative minimum tax" (AMT)
and if this amount is higher than the regular tax bill, he or she pays the higher
amount.
AMT Tax Rate = 26% on First $220,700 of Income
The AMT has been called the "tax on tax preferences." If an investor relies on "tax
preference" items to reduce regular tax liability excessively, the alternative
computation adds back the preference items to taxable income, and a flat 26% tax
rate is applied to the "alternative income" (for such income up to $220,700 in 2023);
for income above this amount, the rate increases to 28%.
37
Tax Preference Items
The main tax preference items are:
Accelerated depreciation amounts in excess of straight-line;
Excess intangible drilling cost deductions. (Oil wells are given an arbitrary 10
year life. 100% of the IDCs are deductible the first year so 90% is "excess");
Excess percentage depletion deductions;
Municipal interest income from bond issues that are "qualified private activity"
bonds, and limited dollar amounts of "non-essential use, private activity" bonds;
Exercise of incentive stock options, where there is a “bargain element.” (For
example, if an employee has the option to buy that employer’s stock at $20 and
exercises when the stock is worth $50, the $30 per share discount is added into
AMT, even though the employee has not sold that stock position.)
As an example, assume that an investor filing an individual return was able to reduce
his regular taxable income to "0" by investing in a functional allocation drilling
program. He was allocated $100,000 of IDCs that year. Under the AMT, here is what
happens:
$0
+
$90,000
$90,000
Regular Taxable Income
Excess IDCs - Add back of Preference Item
Alternate Minimum Income
$90,000 × 26% Tax Rate = $23,400 tax due. This investor must pay tax of $23,400
since it is higher than his regular tax liability (which was zero).
38
Non-Deductible Items In AMT
Finally, you must know for the exam that certain deductions that are permitted in the
Regular income tax calculation are NOT permitted when calculating AMT. This
effectively increases the amount of taxable AMT income. The deductions that are NOT
allowed when computing AMT include:
Personal exemption;
Standard deduction;
State and local tax deduction;
Miscellaneous deductions.
39
Personal Bankruptcy
Finally, a rather unpleasant topic to cover is personal bankruptcy. Consumers who
have debts that are so high, or income that is so low, so they have no ability to repay
their debt, typically file "Chapter 7" bankruptcy. If the consumer has the ability to
repay his or her debt over an extended time frame (typically 3-5 years), then "Chapter
13" bankruptcy is filed
40
Chapter 7 Bankruptcy, Exempted Property Kept by
Debtor
Most personal bankruptcies are Chapter 7. The debtor turns over all "non-exempt"
property to a trustee. Exempted property is allowed to be kept by the debtor and is the
property needed for living and working, such as household goods and furnishings,
clothing, a car (up to a limited value), a portion of equity in a home (set by each State
and usually a low value), tools needed in one's work, etc.
41
Non-Exempt Property Sold and Proceeds Used to Pay
Creditors' Claims
Non-exempt property is sold off by the trustee and used to pay creditors' claims. If a
creditor is secured (such as a mortgage on a home or a car loan secured by the
automobile), that asset is sold by the trustee and the proceeds used to pay off the
secured loan.
If the sale proceeds are less than the amount owed, the lender has no recourse
unless the debtor personally guaranteed the debt.
If, on the other hand, the asset is sold for more than the outstanding debt, the
excess amount is used to pay general creditors' claims.
After all general creditors' claims have been paid (and this is typically a partial
payment), any remaining debt is discharged in bankruptcy (meaning that the debtor is
no longer obligated to repay those debts.)
42
Strategic and Tactical Asset Allocation
The major decision to be made for a client is the allocation of portfolio assets between
equity investments and interest bearing investments. This decision will establish the
basic risk (volatility of the return) versus rate of return characteristics of the portfolio.
43
Balance between Equities and Debt
the portfolio needs to be balanced between interest bearing and equity
investments. The basic tradeoff between the two types of investments is:
Interest bearing investments have lower credit risk and no volatility of return (for
fixed income investments); but the return is susceptible to market risk and
purchasing power risk;
Equity investments have higher credit risk and much greater volatility of return;
but they have proven over time to be able to grow at a faster rate than inflation -
building purchasing power.
Thus, there is a classic trade-off between the two types of investments. Another
factor to consider in balancing the portfolio is the investment time horizon.
Long Term Time Horizon
Over the long term, inflation has proven to be the greatest risk - making equity
investments the better choice for long term time horizons.
Short Term Time Horizon
Over the short term, equity returns can be much more volatile, and can be
negative as well, making interest bearing securities the better vehicle for the
short term.
44
Liquidity Needs
Another factor to consider in portfolio balancing is portfolio liquidity. A portion of the
portfolio needs to remain liquid to meet anticipated (or unanticipated) cash needs.
45
Asset Classes: Equities, Fixed Income, Cash Real Estate,
Commodities
Looking at the "big picture," we have described 3 "asset classes" with differing
characteristics - stock, bonds, and cash/money market instruments. An addition to
these 3 asset classes, real estate and commodities are the other generally recognized
asset classes. Within each asset class are "investment vehicles" that are a subset of
that asset class. For example, growth stocks would be an investment vehicle within
the equities asset class.
Creating an investment portfolio consists of the following steps:
1. Selecting which asset classes will be represented in the portfolio;2. Determining the "target" percentage of the portfolio to allocate to each asset
class;
3. Specifying for each asset class, the allowable range by which the allocation can
be changed to take advantage of market conditions;
4. Selection of the securities within each of the asset classes.
The normal asset allocation is chosen by the manager based on the client's
investment objectives and risk (volatility) tolerance of the customer. The "traditional
portfolio" is one that consists of:
U.S. Government Treasury Bills
Long Term Corporate Bonds
Large Company Stocks
Thus, we have 2 asset classes in this portfolio (Equities and Fixed Income); and have
completed Step 1 above.
46
Strategic Asset Allocation
step 2
2 is the process of selecting a "target" asset allocation - that is, the proportion to
be invested in different types of securities. This is also called strategic asset allocation.
The proportion of assets of each investment vehicle is termed the "portfolio balance"
or the "normal asset allocation." In this beginning example, we have used only 3
investment vehicles - but we can use many more (this will be illustrated later).
The "target" weights chosen will depend on the customer's investment objective, time
horizon, risk tolerance, etc. The overriding objective in such an allocation is to achieve
the highest expected return versus risk (volatility) assumed by the client.
47
Tactical Asset Allocation
step 3
3 is where minimum and maximum limits are set for each investment vehicle's
portfolio proportion. This allows the portfolio manager to take advantage of market
conditions, within the parameters set by the minimum and maximum percentages. In
essence, this is the market timing aspect of the model. If conditions favor one asset
class over another, the manager can "time the market" within the allowed
percentages.
The idea behind the "tactical" minimum and maximum percentages is that it allows
the manager to shift portfolio emphasis based upon market conditions - e.g., in this
case, if equities are performing strongly, the manager may shift the portfolio to 60%
equities from the target 50%, while, say, reducing corporate bonds from the target
30% to 20% - but it precludes the manager from "betting the ranch" on say 100%
equities and running the risk that this was the wrong bet!
48
Dynamic Asset Allocation
Another name for "tactical asset allocation" is "dynamic asset allocation," because it
allows a manager to dynamically overweight asset classes that the manager believes
will outperform and underweight asset classes that the manager believes will
underperform.
Step 4 is the actual selection of the securities to be purchased in each asset class. The
actual selection can either be done in an active manner or a passive manner.
Active Asset Management
Active asset selection is based on the belief that fundamental analysis
performed by an analyst can identify undervalued securities and produce a
superior return within that asset class. In essence, such a strategy seeks to find
inefficiencies in market pricing of specific securities. This is an expensive process;
and the cost of the process must be exceeded by any incremental return
achieved.
Passive Asset Management
Passive asset selection is based on the belief that the market is efficient in
pricing securities; and that an index fund can be used for each class, giving
desired diversification with minimum annual expenses.
Most people erroneously believe that the most important step to the investment
process is Step 4 - the selection of the specific securities in the portfolio.
However, studies over time have shown, again and again, that the most important
Steps are 1 and 2. The primary determinant of investment performance over time is
asset allocation - market timing and security selection have very little to do with the
long term return of the portfolio (this is a very strong argument for index funds, by the
way
49
Investment Vehicles
If we believe that the most important steps in the process are asset class selection
and strategic balancing of each class, then the full range of asset classes should be
considered when creating a portfolio. In order of increasing risk (standard deviation of
returns) and rate of return over long time periods, these investment vehicles are:
Treasury Bills
Treasury / Agency Bonds
International Bonds
Large Capitalization Stocks
Mid-Capitalization Stocks
Small-Capitalization Stocks
International Stocks
REITs
Micro-Capitalization Stocks
In addition, subsets of each of these can be created; for example, international bonds
could be broken out into Developed country debt and Third world country debt; with
differing risk/return characteristics.
50
Market Capitalization segments?
Micro-Cap: Any company whose outstanding market capitalization is less than
$250,000,000
Small-Cap: Any company whose outstanding market capitalization is between
$250,000,000 and $2,000,000,000
Mid-Cap: Any company whose outstanding market capitalization is between
$2,000,000,000 and $10,000,000,000
Large-Cap: Any company whose outstanding market capitalization is between
$10,000,000,000 and $200,000,000,000
Mega-Cap: Any company whose outstanding market capitalization is over
$200,000,000,000
Investors with low risk tolerance and/or short time horizons would have portfolios
weighted towards the upper part of the listing. Investors with high risk tolerance
and/or long time horizons would have their portfolios weighted towards the bottom
portion of the listing.
51
Market Index Fund names
Dow Jones Industrial Average
Consists of 30 large capitalization issues, mainly NYSE listed, with the make-up
of the selections chosen to mirror the U.S. economy.
Standard & Poor's 500 Average
Consists of the 500 largest market capitalization issues of companies
headquartered in the United States.
Value Line Index
Consists of 1,700 stocks of companies listed on the NYSE, AMEX (now renamed
NYSE American) and NASDAQ that are followed by the Value Line Investment
Survey. This is mainly a large cap index.
Wilshire Index
Consists of all common issues listed on the NYSE, AMEX (now renamed NYSE
American) and NASDAQ (now about 3,500 stocks; but the number was closer to
5,000 stocks when the index was started in the 1970s).
Russell 2000 Index
Consists of 2,000 small capitalization issues, mainly NASDAQ and non-NASDAQ
OTC issues.
European, Australasia, Far East (EAFE) Index
Consists of the largest stocks, by market capitalization, of companies based
outside North America. It is the oldest international stock index, started in 1969.
52
Investment Policy Statement (IPS)
Once the proper portfolio composition is selected, this is documented in a statement of
investment policy. Such an investment policy statement (IPS) is used to give the
customer, in writing, a summary of what can be expected from the strategy chosen.
53
Portfolio Rebalancing
Once the portfolio is constructed, the next issue is that, as the investments are held,
the balances may shift due to the relative performance of each of the asset classes. To
rebalance a portfolio is simple - just reallocate money from the overperforming assets
to those that are underperforming.
For example in a bull market, the equities will outperform the other securities in
the portfolio and the equity portion will become larger than the target allocation.
These must be sold to rebalance the portfolio; with the proceeds invested in the
relatively underperforming bonds in the portfolio.
54
Buy and Hold
Rebalancing should be done rather than simply "buying and holding" the original
positions. If one were to "buy and hold," and the portfolio were to go through a bull
market; then just as the bull market was ending, the portfolio would be at its
maximum equity allocation - which is not where you want to be at the beginning of a
bear market! Over the long haul, a buy and hold strategy will tend to:
increase the portion of the portfolio held in equities as a bear market is entered;
and
minimize the portion of the portfolio held in equities as a bull market is entered.
Thus, buy and hold (over the long term) puts the portfolio in the worst possible
position - so rebalancing really is a necessity.
55
Difference between passive and active rebalancing?
Passive Portfolio Rebalancing
Funds are continually reallocated from overperforming asset classes to
underperforming asset classes to maintain the optimal "target" asset mix that
has been previously chosen.
Active Portfolio Rebalancing
Funds are reallocated from underperforming or "market" performing asset
classes to those that the manager believes will outperform the market over the
coming time period. This is essentially "tactical" portfolio rebalancing, and allows
the manager an aspect of "market timing" when rebalancing a portfolio. As with
tactical asset allocation, minimum and maximum percentages are specified to
prevent the "too many eggs in one basket" problem if a bet turns sour.
56
Sector Rotation
A variation on active portfolio rebalancing is a "sector rotation" strategy. Sector
rotation is based on the fact that as the economy moves through the business cycle,
different business sectors tend to outperform at each phase of the business cycle.
57
Diversification
Through diversification, if any one sector gives lower than expected or negative
returns, this will not impact the portfolio as strongly; and other sectors might perform
better than expected to offset such an event.
58
What is Indexing, Tracking Error
Another factor in Step 4 (security selection) is the use of indexed securities. This gives
built-in diversification by simply buying index fund shares that match the asset
classes selected. For example, there are Standard & Poor’s 500 Index funds available,
as well as S&P 400 Mid-Cap funds and S&P 250 Small-Cap Funds. Index fund
managers, who seek to match the performance of a benchmark index, must, in reality,
do better than the benchmark index results to cover the costs of operating the fund
(e.g., brokerage costs, administrative costs, etc.). They cannot be completely passive in
their approach because then they will always underperform the index (the "tracking
error").
59
Index Fund Managers Mainly Employ Passive
Management, but Also Use Active Management to
Reduce the Tracking Error
in order to boost their yield to cover these expenses, they must employ a bit
of active asset management - in essence, making disproportionately large bets on
stocks in the index that they think will outperform the index - in order to juice up their
returns enough to cover fund expenses. The idea is that the positive tracking error
from the actively managed positions will more than offset the negative tracking error
built into the passively managed positions.
60
Financial Leverage
Another way for an asset manager to boost an investment return is through the use of
"leverage." This is the use of borrowed funds to increase the dollar amount invested.
As long as the funds can be borrowed at a lower interest rate than the return on the
investment made with the borrowed funds, this is a profitable strategy.
Positive Financial Leverage
For example, if funds can be borrowed at 4% and then used to make an
investment yielding 5%, there is 1% positive financial leverage.
Negative Financial Leverage
On the other hand, if the cost of borrowing is more than the return on investment
(for example borrowing money at 5% to make an investment yielding 4%), this is
1% negative financial leverage, and the investment would not be made.
61
Bond Portfolio Immunization
Portfolio immunization is the strategy of managing a portfolio to make it worth a
specific amount at a stated date in the future. This strategy is typically used to fund a
known future liability.
For example, assume that a customer needs $50,000 in 10 years. If the customer
buys a safe 10-year zero-coupon obligation with a $50,000 face amount such as
Treasury STRIPS, then the customer will have the needed principal amount 10
years from now.
The intent of bond portfolio immunization is to eliminate interest rate risk. If the
customer were to buy, say, a conventional 30-year Treasury bond to pay off this
liability in 10 years, and interest rates rose substantially in the meantime, those bonds
would drop in value, and the needed funds would not be there in 10 years.
The bottom line is that to immunize a portfolio, the duration of the bonds used to fund
the future liability must match the length of time until the liability must be paid.
62
Bond Contingent Portfolio Immunization
Do not confuse bond portfolio immunization with "contingent" bond portfolio
immunization. Contingent bond portfolio immunization is an "active management"
strategy where the manager attempts to select bonds that will outperform a
benchmark index; but if the portfolio drops below a predetermined value, the manager
shifts to a defensive strategy, buying top-credit rated bonds with a lower rate of
return, but this assures, at least, a minimum return rate.
63
Final Factor in selecting securities?
A final factor to consider when selecting equity securities (Step 4) is whether to bias
the selection based upon "growth" or "value."
Growth Investing
Growth investing is the selection of equity investments based solely on earnings
growth or stock price growth over time. Growth investing ignores fundamental
and technical factors when selecting securities.
Instead, if earnings growth or stock price growth is expected to outpace that
market sector - then investment in these securities should produce superior
returns. Of course, the methodology for choosing these "superior" investments is
the key to the success of such a strategy; and since it is based on historical data,
it is not necessarily predictive of the future. As with all such "predictive"
strategies, it tends not to produce a superior result over a long time frame.
Value Investing Price/Earnings Ratio Price/Book Value Ratio
Value investing is the selection of equity investments based on finding securities
that are fundamentally undervalued in the marketplace. These tend to be solid
companies that are currently "out of favor." Value investors look such
fundamental factors as the Price / Earnings ratio and Price / Book Value ratio to
find companies that are undervalued relative to their market sector. Then, by
examining other fundamental factors such as current products, new products,
management, market share, industry outlook, etc.; those companies that are
expected to perform well over the coming time frame would be selected as good
"values." Over time, the market should recognize the fundamental worth of these
companies and bring the pricing of the shares up to current market multiples.
Momentum Investing
Momentum investing is a type of technical theory. Momentum investors believe
that stocks that have prices moving at high speeds (either up or down) tend to
continue moving rapidly in the same direction - that is, they have "momentum."
So if a stock price is moving up rapidly, just "jump on the bandwagon" by buying
the stock and ride the price up. Of course, these stocks that have rapid price rises
then typically crash and burn when investors become disenchanted with the
stock, so the holder must get out before this happens.
Also Known as Trend Investing, Whisper Number
Momentum investors look for a trend of earnings "surprises" - either positive or
negative, since these trigger the "herd" investment behavior that underlies this
theory. For example, if reported earnings are higher than the "whisper number"
(the market's expected earnings), investors rush in to buy the stock, pushing the
price up, creating the market momentum that underlies this theory.
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Funding Techniques
Once the 4-Step process of portfolio creation is completed, the actual funding of the
portfolio must occur - that is, when is the right time to buy the selected securities.
This comes down to the issue of market timing. One can create a balanced portfolio
that meets the customer's objectives; but if the purchases are all made at the same
time just prior to a market crash, then the portfolio's return may be compromised for
years to come. Of course, if all of the purchases are made at a market "bottom," the
opposite is true - the portfolio's return will be enhanced for years to come during the
ensuing bull market.
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Funding Time Frame, Used Most Often for Mutual Fund
Purchases
Because common stocks are more volatile than bond investments, it is common to use
12–24 month time frames to fully fund common stock portfolios, but only 3–9 month
time frames to fund bond portfolios. In reality, DCA is most often used with mutual
fund purchases, because investing the same fixed dollar amount periodically in mutual
funds buys both full and fractional shares. When making individual common stock or
bond purchases, the fractional units cannot be purchased, so the periodic investment
amount becomes uneven.
66
Reinvestment of Dividends, Interest and Capital Gains
Because investments make periodic dividend and interest payments, reinvestment of
these in the same portfolio positions enhances the "dollar cost averaging" effect over
time. Finally, reinvestment of realized capital gains on positions sold is an additional
dollar cost averaging enhancement.
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DRIP - Dividend Reinvestment Plan
Another way for a customer to fund stock purchases is via a "DRIP" - which stands for
"Dividend Re-Investment Plan." These are plans offered by corporate issuers that give
shareholders the ability to reinvest cash dividends paid by the company in additional
shares of that company. This is a feature similar to automatic reinvestment of
dividends at NAV in a mutual fund.
There are no commission charges on reinvested dividends and fractional shares can
be purchased. The issuer's DRIP allows the shareholder to build an increasing position
in that issuer's stock over time in a passive fashion. Because additional shares are
purchased periodically with the reinvested dividends, this is a form of dollar cost
averaging. The disadvantage of a DRIP is that the investor cannot determine the
timing of these incremental purchases.
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ERISA is?
Retirement plans are tax deferred vehicles for holding investments. Plans can be
established by individuals or by their employers. Plans for individuals are Individual
Retirement Accounts (IRAs) and Keogh Plans. Employer established plans are
regulated under ERISA - Employee Retirement Income Security Act. Plans that comply
with ERISA requirements include:
Profit-Sharing Plans
Defined Contribution Plans
Defined Benefit Plans
Tax-Deferred Annuity Plans (403(b))
Payroll Deduction Savings Plans
ERISA covers private retirement plans. It does not cover public retirement plans such
as those for U.S. Government employees or State employees. These plans are
"exempt" from ERISA requirements.
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ERISA Requirements Include:
Settlor
The plan settlor is the person who establishes the plan, chooses the type of plan,
amends the plan as needed, chooses the plan options, decides the level of matching
contributions (if any) and decides when to terminate the plan. This person is usually a
company executive, making the "business decisions" for the plan. The settlor is not a
fiduciary to the plan.
Fiduciary Responsibility
The plan trustee must manage the assets of the plan in the best interests of all
participants. The trustee can appoint an investment manager, but both have a
fiduciary responsibility to the plan.
Plan assets must be segregated from other company assets. The plan trustee is
prohibited from selling assets to the plan; or from taking commissions on sales of
assets to the plan. For example, it would be prohibited for a broker-dealer to pay a fee
to the plan trustee, in return for plan portfolio transactions directed by the trustee to
the broker-dealer.
Non-Discrimination
All employees must be treated equally under the Act.
Vesting
Employees must "earn" their benefits over a reasonable time period. Once the benefit
is fully vested, it is the property of the employee, even if he or she leaves that firm. The
ownership of employer contributions must occur within either 3 years (under cliff
vesting) or 6 years (under graded vesting). In contrast, employee contributions [such
as those in 401(k) plans] are 100% vested immediately. Employers may require 1 year
of service prior to plan participation.
Party-in-Interest
This is any person who is a participant in the plan; who provides services to the plan;
or who oversees the operations of the plan (e.g., a plan trustee). Such parties-ininterest are prohibited from selling assets to the plan; from using plan assets for their own purposes (e.g., borrowing securities from the plan to effect a short sale for the
trustee's personal account); and from receiving any benefit from the operations of the
plan (e.g., fees, commissions).
Prohibited transactions between the plan and a party-in-interest include:
The sale, exchange or lease of property between a plan and a party-in-interest;
A loan or other extension of credit between a plan and a party-in-interest;
The provision of services, goods or facilities between the plan and a party-ininterest;
The use of plan assets by or for the benefit of a party-in-interest;
The plan investing in employer-owned real property (unless an exemption is
available);
The plan investing in the securities of the employer (unless an exemption is
available).
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Class Exemption for Broker-Dealers
broker-dealers who offer advice to a plan; or who administrate a plan; and
their registered representatives, may be compensated (that is, paid a commission or
fee) on transactions effected for the plan.
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Prohibited Transactions
The plan may prohibit certain types of transactions due to their speculative nature -
e.g., naked option writing. Generally, plans will not allow debt financed purchases
(margin transactions); but will allow covered call writing to increase income from
securities held by the retirement fund.
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Investment Policy Statement (IPS
The overall plan investment strategy and limitations are set forth in the "IPS" - the
Investment Policy Statement. The IPS:
Establishes investment policy and objectives;
Establishes asset allocations to each asset class and permitted tactical variation;
Establishes investment performance and measurement objectives; Establishes
risk limitations for the investment manager.
The investment manager and trustee must comply with the IPS, otherwise they have
breached their fiduciary obligations.
There are two basic categories of pension plans covered under ERISA:
Defined Contribution (DC)
In this plan type, contributions are based on a predetermined formula such as a
percentage of company profits and employee earnings amount. Each year, the
amount earned under the formula must be deposited to the plan. The longer the
employee stays in the plan, the higher the benefit.
Defined Benefit (DB)
In this plan type, contributions are made to fund a given benefit at retirement. An
actuary is used to determine the total plan contribution made each year.
Employees who are older and either retired or close to retirement have a much
greater benefit than younger employees who are far away from retirement age.
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Unfunded Pension Liability in Defined Benefit
Companies are not obligated to fund their entire pension obligation each year in a
defined benefit plan. There are minimum funding requirements specified by ERISA,
which can leave the company with an "unfunded" pension liability. The minimum funding requirements are computed by an actuary. The company is obligated to meet this unfunded liability as time progresses.
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Pension Benefit Guaranty Corp. (PBGC), Covers
Terminated DB Plans with Unfunded Liability
If a defined benefit plan is terminated and has an unfunded pension liability
(termination typically occurs because the company goes out of business), then the
Pension Benefit Guaranty Corporation ("PBGC") covers the unfunded liability so that
the pension obligation is met. Note that PBGC places a cap on this guarantee (the cap
amount is not tested) and PBGC does not cover defined contribution plans - it only
covers defined benefit plans.
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QDRO - Qualified Domestic Relations Order
Another item that must be known for the exam is a QDRO - a "Qualified Domestic
Relations Order" - a judicial order in a divorce or legal separation that splits a
retirement plan into ownership by the 2 divorced individuals.
Because a retirement plan is in the name of only 1 person (say the husband), then
upon divorce, the wife, would have no claim to this asset. If the divorce court in the
State issues a QDRO, the wife becomes an "alternate payee" with the right to receive
a portion of the plan benefits. Note that a QDRO only applies to ERISA plans. Usually
if the participation in the plan started after the date of marriage, each participant's
share becomes 50% under the QDRO. If the participation in the plan predated the
date of marriage, then a formula is used that calculates the alternate payee's share
based only on amounts contributed and earned in the plan after the date of marriage.
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Tax Qualified Plan
Plans are either "tax qualified" or "non-tax qualified." Tax qualified plan contributions
are deductible against the contributor's taxable income. Thus, the contribution
amounts have not been taxed. Earnings in the plan build up tax deferred. When
distributions are taken from the plan, the entire distribution amount is taxable. All
ERISA plans are "tax qualified."
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Non-Tax Qualified Plan
Non-tax qualified plan contributions are not deductible against the contributor's
taxable income. Thus, the contribution amounts have been taxed. Earnings in the plan
build up tax deferred. When distributions are taken from the plan, the portion of the
distribution that represents that "build-up" is taxable; the portion that represents the
original contributions is a non-taxable return of capital (since the original contributions
were made with "after-tax" dollars).
An example of a non-tax qualified retirement plan is a variable annuity purchase. The
contribution amount is not deductible from current year taxes. Earnings build tax
deferred. When distributions commence, the portion of the distribution attributed to
the original investment is a tax-free return of capital; any earnings above this amount
are taxable as income to the annuity recipient.
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IRA
any person qualifies - 6500 maxim
Married Couple Contributes Double
If a married couple is filing a joint tax return, they can contribute 2 times the amount
listed above.
IRA Catch-Up for Individuals Age 50 or Older
In addition, the new tax law permits "IRA Catch-Up" provisions for taxpayers over 50
years old. For the tax year 2023, these individuals can contribute an extra $1,000 to
the amount listed above.
Contribution Based upon Earned Income
The contribution is only based on payments received for rendering personal services.
Income received from investments is not counted. Contributions for each tax year can
be made until April 15th of the following year.
If Not Covered by Qualified Plan - Deductible
If the person making the contribution is not covered by another pension plan, the
contributions are always tax deductible in full.
If covered by qualified plan an income is too high - not deductible (73-83k single) (116-136k married)
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IRA & Roth Contribution Rules
If the maximum contribution is made to a Traditional IRA; then a contribution cannot
be made to a Roth IRA (and vice-versa). Contributions of high income persons are
subject to phase-out. The phase-out range (in 2023) starts for individuals with income
above $138,000, with full phase-out at $153,000. The phase-out range for couples
starts at $218,000, with full phase-out occurring above $228,000 of income.
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Conversion of Traditional IRA into Roth IRA
Traditional IRA account holders are permitted to "convert" their IRAs into Roth IRAs,
as long as they pay taxes on any amount converted (but then the account builds taxfree).
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IRA Contributions Must Be Made by Tax Filing Date No
Extension
contributions to any IRA (Traditional or Roth) must be made by April
15th of the following year (the tax filing date) - without any permitted extensions.
(That is why January 1st to April 15th is called "IRA season" at many brokerage firms!)
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Permitted Investments
The allowed investments include CDs, stocks, bonds, unit trusts, mutual funds,
government securities, annuities, and gold and silver coins minted by the U.S. Treasury
and precious metals bullion (palladium, platinum, gold and silver). Allowed, but rarely
seen in IRAs, is direct investment in real estate. (Most IRA trustees will not permit this,
since such illiquid assets make it difficult to make mandatory cash distributions that
must start at retirement age.) Another rarely seen, but permitted, investment is an
annuity contract, since it is already tax deferred, so why buy it within a tax-deferred
vehicle?
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Prohibited Investments
Insurance policy "cash" values; term insurance, art and collectibles are not allowed
investments for IRAs.
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Payout Must Be Made by December 31 Each Year After
Turning 73
Distributions must commence by December 31 each year after reaching age 73. The
minimum distribution amounts are established by IRS tables.
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Roth IRAs Not Subject to Age 73 Withdrawal
Requirement and Are Not Taxable
, please note that Roth IRAs are not subject to the requirement to begin
distributions at age 73; and contributions into a Roth IRA are permitted to continue
after this age, as is the case with all retirement plans. Also, remember that
distributions from a Roth IRA are not taxable, as long as the investment has been held
for 5 years and as long as the person is at least age 59 ½
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IRA Rollover - 60 Days
If a person has participated in another pension plan that has been terminated, or that
person leaves employment and receives their pension benefit as a lump-sum, he or
she can "roll-over" the proceeds into an IRA without dollar limit.
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Once per Year
The rollover must be completed within 60 days of the distribution date. Thus, that
person's retirement funds continue to build up tax deferred. If an IRA rollover is not
made, the distribution amount is taxable.
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20% Withholding Tax on Premature Distributions
To ensure that tax due will be paid if the distribution is not rolled over into an IRA, the
IRS requires that 20% of the distribution amount be withheld as a credit against the
tax liability for having taken the premature distribution. Translated, this means that if
a check is written to the name of the beneficiary, 20% of the amount must be
withheld
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IRA Transfer, Direct between Trustees
If a person wishes to transfer IRA assets from one trustee to another, transfers must
be effected directly between trustees. An unlimited number of transfers can be
effected each year. Please note that if the transfer is not made directly, it is considered
an IRA rollover, as just discussed. Furthermore, there is no withholding tax
requirement on such transfers.
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To Harvest Tax Losses in an IRA, Must Close All IRA
Accounts and Sell the Assets for Less Than the
Aggregate Basis
Another point about IRAs that must be known for the exam is how to harvest a "tax
loss" if a client has depreciated securities positions held in an IRA. If a client has
substantial losses in an IRA account, the only way for the customer to get a tax
deduction for these is to close all of his or her IRA accounts (or Roth IRA accounts),
liquidate the assets, and as long as the proceeds from the liquidation are less than the
customer's basis in all the accounts (which is the aggregate amount of all nondeductible contributions plus any amounts converted from a Traditional IRA to a Roth
IRA), the customer will have a tax-deductible loss.
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Distribution of IRA Assets upon Death
Finally, if a person owning an IRA dies prior to distribution of assets, the value of the
IRA is included in that person's taxable estate. Distributions from the IRA are taxable
as ordinary income to the extent that they exceed the IRA's cost basis (which is the
accumulated amount of contributions made that were not tax deductible). The IRS
requires that such distributions be made over either 5 years; or over the remaining life
of the "designated beneficiary" - which is the beneficiary that has the shortest
expected life.
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Money Purchase Plan - other retirement plan types
In this plan type, contributions are based on a predetermined formula such as a
percent of company profits or employee earnings. The maximum contribution is
25% of income (statutory rate; 20% effective rate), capped at $66,000 in 2023.
Plans based on a percent of salary are sometimes called "Money Purchase"
Plans. The amount earned under the formula must be deposited to the plan
annually, regardless of whether the company is profitable or not. The longer the
employee stays in the plan, the higher the benefit.
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Profit-Sharing Plans- other retirement plan type
Tax qualified profit-sharing plans allow a company to share its profits with its
employees. This is a defined contribution plan subject to ERISA. Contributions
are based on company profits; however, the actual yearly contribution amount is
decided by the employer. Contributions made by the employer are tax deductible;
the plan can also allow for contributions made on the part of the employee which
are also deductible (to the employee). Under this type of plan, the maximum
contribution is 25% of employee compensation up to $66,000 in 2023. All
earnings are tax deferred.
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Deferred Compensation Plan - other retirement plan
Under this plan type, portions of income are deferred until retirement or death. A
contract is drawn between the employer and the employee which specifies the
amount deferred and the requirements for receiving the deferred amount. If these
are not met, no payments are made. This is a non-qualified plan which requires
no IRS approval, nor is it subject to ERISA. Income taxes are not due until the
funds are actually received, and so the plan is tax deferred.
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Payroll Deduction Savings Plan (401(k) Plan)
Under this plan, for-profit employers match (within specified limits) employee
contributions to savings plans. This is a type of defined contribution plan, commonly
known as a 401(k). The plan allows employee contributions to be excluded from
taxable income. The employer can match these contributions. The annual contribution
is limited to a maximum dollar amount of $22,500 for tax year 2023. Catch-up
contributions for those age 50 or over allow for additional contributions of $7,500.
Build-up is tax deferred. When payments are taken, 100% is taxable. This is a tax
qualified plan, subject to ERISA. Participation in the plan and contributions made into
the plan are completely voluntary on the part of the employee; and any matching
contributions by the employer are set by the employer at its option, within limits
specified for 401(k) plans.
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401(k) Loan, Loan Default
A loan can be taken from a 401(k) or 403(b) account for any reason. The maximum
amount that can be borrowed is $10,000 or 50% of the account asset value,
whichever is greater, capped at a $50,000 maximum loan. The loan must have an
interest rate that is based on current market rates and must be repaid within 5 years.
Repayment must be made in quarterly installments of "substantially equal amounts."
If any portion of the loan is not repaid, the unpaid amount becomes taxable income,
and if the account owner is under age 59 1/2, then the 10% penalty tax applies as
well.
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Employer Match Can Be Paid Directly to Student Lender
To help pay down student debt, which can be an enormous burden, the IRS has issued
a letter ruling that permits companies to make matching 401(k) payments directly to a
student loan provider, instead of depositing the funds to an investment account in the
name of the plan participant. Of course, there are quite a few qualifying
considerations, but the basic “idea” is to try to pay down student debt.
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Safe Harbor 401(k)
Traditional 401(k) plans give the employer the "option" of making matching
contributions. These contributions can be subject to a vesting schedule (usually,
employer paid benefits vest at the rate of 20% per year).
Furthermore, the plan must be tested annually to make sure that it does not favor
highly compensated employees (HCEs). A plan that is not subject to this annual
benefits testing is a "safe harbor" 401(k). In exchange for avoiding annual testing,
these plans must get a minimum level of mandatory employer contributions (the
employer must either match the first 4% of compensation for participating employees
or must match 3% of employee compensation for each eligible employee, regardless
of whether the employee chooses to participate). Furthermore, these contributions
must vest immediately
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Conversion of 401(k) into Roth IRA
401(k) participants are permitted to "convert" their accounts into Roth IRAs, as long
as they pay taxes on any amount converted (but then the account builds tax-free).
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ERISA Rule 404(c)
ERISA Rule 404(c) applies to retirement plans that offer "self-directed" investment,
such as 401(k) plans. It requires that the plan sponsor offer:
3 Investment Alternatives
at least 3 investment alternatives that are diversified; that have materially
different risk and return characteristics; and that when combined with each
other, tend to minimize risk through diversification (e.g., an equity fund, a fixed
income fund, and a capital preservation fund);
participants the opportunity to diversify their account sufficiently to avoid large
losses; and
participants the opportunity to change investments with a frequency appropriate
to the volatility of the investment.
Note that the sponsor can offer its own stock as an asset class (e.g., an employee of
GE can be offered GE stock as an investment option), as long as the stock is publicly
traded and the participant gets the voting rights.
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404(c) Relieves Fiduciary of Liability for Poor Choices
Among Options Offered
If a plan sponsor complies with Rule 404(c), then the plan fiduciary is relieved of
liability for poor choices made by plan participants (e.g., an older participant putting
100% of his or her pension money in an aggressive growth fund just before the start
of a bear market). Note, however, that the fiduciary is still liable for offering poor (e.g.,
overly expensive or underperforming) investment options.
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Tax-Deferred Annuities ("TDA") (403(b) Plan)
Normally, annuities are non-tax qualified. However, employees of non-profit
organizations, such as schools, hospitals, and foundations, are allowed to contribute
to "tax-qualified" annuities - either fixed or variable contracts. In addition, investments
in certain types of mutual funds are permitted. The contributions are tax deductible,
and the earnings are tax deferred; so that all payments received are 100% taxable.
Generally, the maximum annual contribution to such plans is 25% (statutory rate) of
income, up to $22,500 (for tax year 2023). Catch-up contributions for those age 50 or
over allow for additional contributions of $7,500. Note that this is known as a "salary
reduction" plan, in that any amounts contributed reduce the employee's taxable
income. Participation in the plan and contributions made into the plan are completely
voluntary on the part of the employee.
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No 10% Penalty for Withdrawals in Equal Installments
after Age 55
A little known rule for both 401(k) and 403(b) plans is that if an employee quits or is
terminated between the ages of 55 to 59 1/2, the "Rule of 55" can be applied. This IRS
rule allows the terminated employee to take payments in equal installments over his
or her life expectancy and avoid the 10% penalty tax. Note that regular income tax
must still be paid.
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457 Plans Salary Deferral Plans for Highly
Compensated Government Employees
457 plans are deferred compensation plans for government employees of states,
counties, cities, their agencies and political subdivisions, as well as tax-exempt
organizations other than churches. These plans are nonqualified plans that typically
cover management and highly compensated personnel. Section 403(b) plans cover the
rank-and-file employees. The maximum amount that employees may defer into a 457
plan for 2023 is $22,500 or 100% of salary, whichever is less. Catch-up contributions
for those age 50 or over allow an extra $7,500 contribution.
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No 10% Penalty Tax for Withdrawals Prior to Age 59½
An advantage of a 457 plan as compared to an IRA, 401(k) or 403(b) plan is that
withdrawals can be made prior to age 59½ without the 10% penalty tax, however
regular income tax is still due. This is permitted because very often the participants in
457 plans are police officers and firemen who might have to retire earlier than age
59½ due to disability - so they can get the funds in the 457 account to help pay for
needs caused by forced early retirement without paying the 10% penalty tax.
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Life Cycle Funds, Age Weighted Investing
As a final note for all retirement plan types, mutual fund companies have addressed a
major issue in retirement planning by offering so-called "life cycle" funds or "age
weighted funds." A younger customer with many years to retirement would want to
weight his investment portfolio more towards growth stocks and other "higher risk"
investments that do not offer current income, but do offer the potential of greater
capital appreciation. However, in later years, the customer is looking more towards
"safety" and getting current income.
A general rule of thumb for asset allocation is to take "100 minus that person’s age" to
get the percentage of that individual’s portfolio that should be invested in equities.
The balance should be invested in safer fixed income securities.
So, as a rough guide, an individual, age:
30, would have 70% of assets invested in stocks and 30% in bonds;
50, would have 50% of assets invested in stocks and 50% in bonds;
70, would have 30% of assets invested in stocks and 70% in bonds.
As the customer ages, these "life cycle" mutual funds will shift the customer’s
investments to mutual funds that are more conservative in their approach; and when
the customer reaches retirement age, the funds are shifted to a very "safe" mutual
fund that offers current income. Thus, the customer does not have to be concerned
with shifting and rebalancing his portfolio as he ages.
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Coverdell ESAs
Coverdell ESAs (Education Savings Accounts) that are targeted at middle income
taxpayers and that allow for tax-free saving for all types of qualified education
expenses, including private grade and secondary school expenses. These plans
only allow $2,000 per year to be contributed per recipient and they are not
available to high-earning individuals. Many retail brokerage firms do not offer
them, since the client demographic and small investment amount do not meet
their requirements.
No Tax Deduction for Contribution
Contributions are not tax deductible. Additional contributions are not permitted into a
Coverdell after the beneficiary reaches the age of 18.
Earnings Build Tax-Free When Used to Pay for Qualified
Education Expenses
Funds Must Be Used by Age 30
If Funds Are Not Used Up or Are Used Improperly -
Regular Tax Plus 10% Penalty Tax
Coverdell ESAs Are Not Available to High-Earning
Individuals
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529 Plans
529 Plans are essentially mutual fund investments offered in a state-sponsored
"wrapper." Unlike Coverdell ESAs, they can only be used to pay for higher
education (college and higher). Also, unlike Coverdell ESAs, there are no highincome phase out rules and contribution amounts, which are set by each state,
can be very high (often as high as $300,000 total.)
Qualifying Distributions without Limit for Higher
Education and up to $10,000 Per Year for Below College
Level Expense or $10,000 Lifetime Limit on Student
Loan Payoff
Can Make Annual Contributions to Both a 529 Account
and a Coverdell Account
Rollover Permitted Every 12 Months
Also note that a tax-free rollover of a 529 Plan for the same beneficiary is permitted
every 12 months. This is useful if the donor moves to another State, especially if that
State where the account is moved has a higher contribution limit
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Definitions of the Trading Markets
Negotiable securities trade in specific "markets." The overall marketplace for securities
is divided into the:
Primary Market
New issues being sold to the public for the first time; and
Secondary Market
Trading of issued securities.
Secondary Market Subdivisions
The secondary market is divided into 4 submarkets. These are called the:
First Market;
Second Market;
Third Market;
Fourth Market.
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First Market, Trading on Exchange Floors
The first market is trading of exchange listed securities on the floor of the stock
exchange. This was the first market, as the New York Stock Exchange (NYSE) is a bit
over 200 years old. The largest stock exchange by far is the NYSE.
These exchanges have specific listing standards for companies that wish their stocks
to be traded, both requiring that companies have a national investor base to be listed.
As of this writing, on average 2 billion shares change hands on the NYSE each day,
spread among approximately 2,500 listed companies. This is a very active trading
market.
111
Brokers & Dealers
In order to function, markets must be liquid. Orders to buy and sell must be filled at all
times. It is the function of the dealers to make markets in securities. Dealers are
expected to maintain an inventory of each security in which they make a market: to
buy if a customer wishes to sell, and to sell if a customer wishes to buy.
112
Dealer Quotes in Bid and Ask, Spread
Dealer quotes are in terms of Bid and Ask. The Ask price is the price at which the
dealer will sell the security. The Bid price is the price at which the dealer will buy the
security. To make a profit, the Ask price is always higher than the Bid - the difference
is the spread - the dealer's gross profit margin.
113
Active Markets Characterized by Narrower Spreads
The more active the trading market, the narrower the spreads become. This makes the
market more "efficient" and is better for customers, since the "spread" gives the
customer a built-in loss (the customer in this example buys at $13.50, but can only sell
for $13.00) that is recovered only if the market price moves up.
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Designated Market Makers (DMM), Are Dealers on NYSE
On stock exchanges (First Market), the dealers are called Designated Market Makers
(DMM). On the NYSE, there are about 5 DMM firms handling the approximately 2,500
NYSE listed issues, so each DMM firm handles about 500 different stocks. The DMM is
the sole market maker in that stock.
115
Designated Market Makers (DMM) Do Not Deal with the
Public
Designated Market Maker (DMM) firms are prohibited from dealing with the public.
They are wholesalers of securities and only deal with the retail members of the NYSE.
Retail members (firms such as Raymond James or Wells Fargo Advisors, etc.) accept
customer orders and go to the exchange floor to execute the trade with the DMM. For
acting as a middleman (broker), the retail firm earns a commission.
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Designated Market Maker = Specialist
There is only 1 DMM assigned to each stock on the NYSE. Also know that the
DMM is also called a Specialist.
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Continuous Market
The DMM must make a continuous market in the stock and acts as the buyer or
seller of last resort if there is no one else willing to trade on the floor.
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Bid - Ask Quote
If a DMM is quoting a stock at $20 - $21, this is called a bid and ask quote. The
DMM is bidding $20 for the stock and is willing to buy that stock at $20 at this
moment. The DMM is asking $21 for the stock and is willing to sell that stock at
$21 at this moment.
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OTC Market
Stocks that don't meet exchange listing standards are traded "Over-the-Counter" -
OTC. The OTC market is comprised of market makers (dealers) who maintain an
inventory of these thinly traded stocks. Because the market is thin, trading volumes
are low and dealer bid-ask spreads are wide.
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Order Ticket Information
To place an order in the secondary market, a registered representative fills out an
order ticket (this is done electronically). The information on the order ticket is used to
wire the order to the exchange or to the firm's over-the-counter trading desk.
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Short Sale Fundamentals
To understand the mechanics of a short sale, one must have a basic understanding of
customer margin accounts. When a customer opens a margin account, buying
securities with credit extended by the brokerage firm, the brokerage firm takes all of
the securities held in the account as collateral for the loan, and keeps them in the
name of the brokerage firm.
The brokerage firm has the right to lend these securities to anyone else. If another
customer wishes to sell short this stock, the brokerage firm simply "borrows" the first
margin customer's securities and sells them (this is a "short sale"). At a later date, the shares are repurchased by the second customer and replaced in the vault. Below is a
more detailed short sale example.
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Types of Orders
Market Order;
Limit Order;
Stop Order;
Stop Limit Order.
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Market Order, Market Not Held
A market order is to be filled immediately at the prevailing market price. There is no
price specified on the order. A market order - NOT HELD is to be filled at whatever
time and price the trader thinks best - but it must be completed that day. Thus, market
orders do not carry over to the next day
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Limit Order Specifies a Price
Limit orders specify a price at which to buy or sell. To understand how these orders
(and stop orders) are used, you must focus on the security's price at the time the order
is placed.
Assume that XXX stock is now trading at 70. A customer wishing to buy XXX stock at
this price would simply place a market order. But what if the customer only wants to
buy at 65 or lower? The order would be placed as:
Buy 100 XXX @ 65 GTC
(Buy Limit order)
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Buy Limit Order
A limit order to buy has been placed (the price is the limit). The order was placed GTC,
because it would be canceled at the end of the day if it were a Day order.
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Placed below Current Market
If the market falls to 65 or lower, the order will be filled. Thus, limit orders to buy are
placed BELOW the current market and are executed only if the market DROPS. Again,
with XXX trading at 70, a registered representative has a customer who wishes to sell
XXX stock that he owns (a long sale) if the price reaches 75. The following order
would be placed:
Sell 100 XXX @ 75 GTC
(Sell Limit order)
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Sell Limit Order, Placed above Current Market
A limit order to sell has been placed (the price is the limit). The order was placed GTC,
because it would be canceled at the end of the day if it were a Day order. If the market
rises to 75 or higher, the order will be filled. Thus, limit orders to sell are placed ABOVE
the current market and will be executed only if the market RISES
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Specialist Acts as "Broker's Broker"
Limit orders to buy and sell are given to the Specialists on the stock exchanges. The
Specialist is at the center of trading and executes these orders for the retail firms. In
this case, the Specialist is acting as a broker for another brokerage firm, "a broker's
broker."
For performing this function, the retail firm shares its commission with the Specialist.
So, in addition to acting as a dealer, Specialists handle limit orders for retail firms,
acting as a "broker's broker."
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OTC File of Open Limit Orders
"Over-the-counter" trading desks at each firm keep a file of limit orders and execute
them if the market price moves to the customer's limit.
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Limit order summary
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Buy Stop Summary
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OBSLOBS
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ROI Formula
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Yield Spread Narrow Vs Wide Meaning
Widening Spread Indicates Coming Recession/ Narrowing Spread Indicated Coming Expansion.
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Tax basis for a security is?
the amount the investor paid for the security plus any commission paid
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What is a C corporation
C corporations can issue both common stock and preferred stock. They can have an unlimited number of shareholders. C corporations are taxable entities. Finally, C corporation common shareholders have the right to vote, but they cannot vote on dividends - this decision is made by BOD.
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What is marginal tax rate?
The rate imposed on the the last dollar received
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How to find corporate equivalent tax rate?
divide the municipal rate by 1 minus tax rate
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Taxable income of a corporation includes
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What is real rate of return?
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What are the trading markets?
1st Market - trading of exchange listed securities on stock exchanges 2nd market - trading of unlisted securities over-the-counter, 3rd market - trading of exchange listed securities over the counter
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how do you calculate short account equity?
credit balance - short market value = equity
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What is earnings per share?
