Series 7 Chapter 2

Question 1

cash account

Answer 1

is the most basic investment account. Anyone eligible to open an investment account can open a cash account. In a cash account, a customer pays in full for any securities purchased.
Certain accounts must be opened as cash accounts, such as personal retirement accounts (individual retirement accounts and tax-sheltered annuities), corporate retirement accounts, and custodial accounts (Uniform Gift to Minors Act and Uniform Transfers to Minors Act accounts).

Question 2

TOD

Answer 2

This is an account that allows the registered owner of the account to pass all or a portion of it, upon death, to a named beneficiary. This account avoids probate (having the decedent’s will declared genuine by a court of law) because the estate is bypassed. However, the assets in the account do not avoid estate tax, if applicable.
TOD accounts are available for individual accounts and for certain joint accounts (joint tenants with rights of survivorship).

Question 3

Inheritance

Answer 3

When a person dies and leaves securities to heirs, the cost basis to the recipient is the FMV on the date of the owner’s death

Question 4

Margin Account

Answer 4

In a margin account, the customer can use some cash and some credit to purchase securities. This is a leveraged purchase of securities; investors can buy more securities with some cash and some credit than they can purchase with just cash. The firm can lend funds at the time of purchase, with the securities in the portfolio serving as collateral for the loan. This is called buying securities “on margin.” The shortfall between the purchase price and the amount of money put in is a loan from the brokerage firm, and the customer will incur interest costs, just as with any other loan.
Margin transactions are not available for use within mutual funds, retirement accounts, or in custodial accounts for minor children.

Question 5

prime brokerage account

Answer 5

A prime brokerage account is one in which a customer, generally an institution, selects one member firm (the prime broker) to provide custody, trading and other services, while other firms, called executing brokers, typically execute most of the trades placed by the customer. To open a prime brokerage account for a customer, a member (the prime broker) must sign an agreement with the customer, spelling out the terms of the agreement, as well as names of all executing brokers the customer has contracted with. The prime broker will then enter into written agreements with each executing broker named by the customer. The customer receives trade confirmations and account statements from the prime broker, who facilitates the clearance and settlement of the securities transactions. Responsibility for compliance of certain trading rules rests with the executing brokers.
The key advantage of a prime brokerage account is that it usually provides a client with the ability to trade with multiple brokerage houses while maintaining a centralized master account with all of the client’s cash and securities. A prime brokerage account often includes a list of specialized services, such as securities lending, margin financing, trade processing, cash management, and operational support. Prime brokerage accounts are likely to be offered to a BD’s more active trading clients, like hedge funds, for example, who may require a number of executing broker outlets to conduct their transactions and who can benefit by having margin requirements that are netted across all of the prime broker’s positions.

Question 6

Fee based account

Answer 6

Many firms offer investors fee-based accounts that charge a single fee (either fixed or a percentage of assets in the account) instead of commission-based charges for brokerage services. Fee-based accounts are not wrap accounts.

Question 7

Wrap account

Answer 7

Wrap accounts are accounts for which firms provide a group of services, such as asset allocation, portfolio management, executions, and administration, for a single fee. Wrap accounts are generally investment advisory accounts.

Question 8

advisory account

Answer 8

An advisory account is an account through which a Registered Investment Adviser (RIA) or an Investment Adviser Representative of the RIA provides investment advice to clients for a fee. It is important to understand that an advisory account is very different from a brokerage account. In a brokerage account, a fee is paid when transactions occur. In advisory accounts, a fee is paid for advice regarding the securities in the account. An RIA has a fiduciary obligation (is legally obligated) to act in the best interests of clients at all times. RIAs must provide clients with a Form ADV which describes how they do business, reveals any potential conflicts of interest, and clearly describes how they are compensated.

Question 9

transfer and ship

Answer 9

Securities are registered in the customer’s name and shipped to them.

Question 10

transfer and hold in safekeeping

Answer 10

Securities are registered in the customer’s name, and the BD holds them in safekeeping.

Question 11

Holding in street name

Answer 11

Securities are registered in the BD’s name and held by the BD. Although the BD is the securities’ nominal owner, the customer is the beneficial owner.

Question 12

delivery vs payment

Answer 12

DVP securities are delivered to a bank or depository against payment. Normally used for institutional accounts, this is a cash-on-delivery settlement. The BD must verify the arrangement between the customer and the bank or depository, and the customer must notify the bank or depository of each purchase or sale. In addition, the customer designates whether the BD should hold or forward any cash balance.

Question 13

single(individual) account

Answer 13

Has one beneficial owner

he account holder is the only person who may:
■ control the investments within the account; and
■ request distributions of cash or securities from the account.

Question 14

joint account

Answer 14

In a joint account, two or more adults are named on the account as co-owners, with each allowed some form of control over the account. In addition to the appropriate new account form, a joint account agreement must be signed.
The account forms for joint accounts require the signatures of all owners. Joint account agreements allow any or all tenants to transact business in the account. Checks must be made payable to the names in which the account is registered and must be endorsed for deposit by all tenants (although mail need be sent to only a single address). To be in good delivery form, securities sold from a joint account must be signed by all tenants.
The suitability requirements for a joint account follow the same basic rules as all accounts—put the interest of the client first. Because a joint account is really nothing other than a collection of individuals, suitability information must be obtained on all of the account owners and any recommendations must be appropriate based upon that information. In other words, the suitability of recommendations must be based on the group, not on any individual within the group.

Question 15

Joint tenant with rights to survivorship

Answer 15

JTWROS ownership stipulates that a deceased tenant’s interest in the account passes to the surviving tenant(s).

Question 16

Tennants in common

Answer 16

TIC ownership provides that a deceased tenant’s fractional interest in the account be retained by that tenant’s estate and not passed to the surviving tenant(s). If one account owner dies or is declared incompetent, all pending transactions and outstanding orders must be canceled immediately.

Question 17

Community property

Answer 17

is a marital property classification recognized by some—but not all—states. In these jurisdictions, most property acquired during the marriage is considered to be owned jointly by both spouses and would be divided at the time of divorce, annulment, or death. Joint ownership is therefore automatically presumed by law in these jurisdictions, absent any specific evidence that would point to a contrary conclusion for any item of ownership. Exceptions are made for inheritances, gifts, or any property that is owned by one spouse before marriage, which is considered the separate property of that spouse, unless it was designated to be owned jointly by both spouses during the marriage.
It is important to know that laws in jurisdictions where community property is presumed differ from state to state. Additionally, community property can have certain federal tax implications. Generally, community property may result in lower federal capital gains taxes after the death of one spouse when the property is dissolved by the surviving spouse. Some states have created separate classifications called “community property with rights of survivorship” that are similar to joint tenancy with rights of survivorship property designations.

Question 18

sole proprietorship

Answer 18

This is the simplest form of business organization and is treated like an individual account. In a sole proprietorship, all income (or loss) is that of the individual. In fact, one of the risks of operating in this fashion is that all the owner’s assets are liable for the debts of the business— you can lose everything. Obviously, this is one of the major considerations when opening an account for this form of business.
This is an account that is easy to create and easy to dissolve.

Question 19

partnership

Answer 19

A partnership is an unincorporated association of two or more individuals. Partnerships frequently open cash, margin, retirement, and other types of accounts necessary for business purposes.

Question 20

partnerships must complete a _____

Answer 20

partnership agreement stating which of the partners can make transactions for the account. If the partnership opens a margin account, the partnership must disclose any investment limitations.
An amended partnership agreement must be obtained each year if changes have been made.

Question 21

corporate accounts

Answer 21

A registered representative who opens a corporate account must establish:
■ the business’s legal right to open an investment account,
■ an indication of any limitations that the owners, the stockholders, a court, or any other entity has placed on the securities in which the business can invest, and
■ who will represent the business in transactions involving the account.

Question 22

corporate charter

corporate resolution

Answer 22

When opening an account for a corporation, a firm must obtain a copy of the corporate charter and corporate resolution

The charter is proof that the corporation does exist, and the resolution authorizes both the opening of the account and the officers designated to enter orders.

Question 23

dividend exclusion rule

Answer 23

Dividends paid from one corporation to another are 50% exempt from taxation. A corporation that receives dividends on stocks of other domestic corporations, therefore, pays taxes on only 50% of the dividends received. This provision encourages corporations to invest in common and preferred stock of other U.S. corporations.

Question 24

numbered accounts

Answer 24

If requested, a customer’s account may be identified by only a number or symbol. The customer must sign a form certifying that he owns the account(s) identified by the number or symbol and must supply other information identifying himself as the owner.

Question 25

fiduciary and custodial accounts

Answer 25

When securities are placed in a fiduciary, or custodial, account, a person other than the owner initiates trades. The most familiar example of a fiduciary account is a trust account.
Money or securities are placed in trust for one person, often a minor, but someone else manages the account. The manager or trustee is a fiduciary.
In a fiduciary account, the investments exist for the owner’s beneficial interest, yet the owner has little or no legal control over them. The fiduciary makes all the investment, management, and distribution decisions and must manage the account in the owner’s best interests. The fiduciary may not use the account for her own benefit, although she may be reimbursed for reasonable expenses incurred in managing the account.
Securities bought in a custodial account must be registered in such a way that the custodial relationship is evident.

as custodian for the account of Johnson’s minor daughter, Alexis. The account and
Marilyn Johnson, the donor, has appointed her daughter’s aunt, Barbara Wood, the certificates would read “Barbara Wood as custodian for Alexis Johnson.”
The beneficial owner’s Social Security number is used on the account.
A fiduciary is any person legally appointed and authorized to represent another person, act on his behalf, and make whatever decisions are necessary to the prudent management of his account. Fiduciaries include:
■ a trustee designated to administer a trust;
■ an executor designated in a decedent’s will to manage the affairs of the estate;
■ an administrator appointed by the courts to liquidate the estate of a person who died intestate (without a will);
■ a guardian designated by the courts to handle a minor’s affairs until the minor reaches the age of majority or to handle an incompetent person’s affairs;
■ a custodian of a Uniform Gift to Minors Account (UGMA) or a Uniform Transfer to Minors Account (UTMA);
■ a receiver in a bankruptcy; and
■ a conservator for an incompetent person.
Any trades the fiduciary enters must be compatible with the investment objectives of the underlying entity.

Question 26

opening a fiduciary account

Answer 26

Opening a fiduciary account may require a court certification of the individual’s appointment and authority. An account for a trustee must include a trust agreement detailing the limitations placed on the fiduciary. No documentation of custodial rights or court certification is required for an individual acting as the custodian for an UGMA or UTMA account. The registered representative for a fiduciary account must be aware of the following rules.
■ Proper authorization must be given—the necessary court documents must be filed with and verified by the BD.
■ Speculative transactions are generally not permitted.
■ Margin and option accounts are only permitted if authorized by the legal documents
establishing the fiduciary accounts.
■ The prudent investor rule requires fiduciaries to make wise and safe investments.
■ Many states publish a legal list of securities approved for fiduciary accounts.
■ A fiduciary may not share in an account’s profits but may charge a reasonable fee for services.

Question 27

death of an account holder

Answer 27

With regard to individual accounts, once a firm becomes aware of the death of the account owner, the firm must cancel all open orders, mark the account “deceased,” and freeze the assets in the account until receiving instructions and the necessary documentation from the executor of the decedent’s estate. If the account has a third-party power of attorney, the authorization is revoked.

Question 28

discretionary authority ends

Answer 28

at the death of the account owner

Question 29

Depending on the type of account, the documents necessary to release the assets of a
decedent are:

Answer 29

a certified copy of the death certificate;
■ inheritance tax waivers; and
■ letters testamentary.

Question 30

3 steps at death of customer

Answer 30

cancel open orders
freeze account(mark deceased)
await instructions from the executor of the estate

Question 31

finra rule 21111

Answer 31

FINRA’s suitability rule (FINRA Rule 2111) is based on a fundamental requirement to deal fairly with customers. Firms and their associated persons “must have a reasonable basis to believe” that a recommended transaction or investment strategy involving securities is suitable for the customer.
The more information a representative has about a customer’s income, current investment portfolio, retirement plans, and net worth, as well as other aspects of the customer’s financial situation, the better a recommendation will be. The more a customer knows about the risks and rewards of each type of investment, the better the customer’s investment decisions will be. Both financial and nonfinancial information must be gathered before making investment recommendations.

Question 32

new account form

Answer 32

Knowing your customer begins with the new account form. The SEC requires that brokerage firms attempt to create a record for each account with an individual customer that includes the following information:
■ Customer name
■ Tax identification number (e.g., Social Security number)
■ Address
■ Is the client of legal age?
■ Telephone number
■ Drivers license, passport information, or information from other government-issued identification
■ Employment status and occupation
■ Whether the customer is employed by a brokerage firm
■ Annual income
■ Net worth
■ Account investment objectives

Question 33

Rules on customer signature for new account form

Answer 33

The customer’s signature is not required on the new account form. The only signature required to open an account is a partner, officer, or manager (a principal) signifying that the account has been accepted in accordance with the member’s policies and procedures for acceptance of accounts.

Question 34

4 items that must be on new account form

Answer 34

Name
■ Address (not a PO Box)
■ Social Security number or tax identification number
■ Date of birth

Question 35

If a customer only provides minimum information and refuses to provide all information requested, the account may still be opened if the firm believes the customer has the financial resources necessary to support the account. If sufficient information has not been received to determine suitability,

Answer 35

recommendations cannot be made and only unsolicited trades may occur.

Question 36

trusted contact person

Answer 36

If the person opening the account is age 65 or older, FINRA requires members to make reasonable efforts to obtain, for noninstitutional customers, the name of and contact information for a trusted contact person age 18 or older who may be contacted about the customer’s account. The rules do not require a customer to provide trusted contact information.
Member firms may place a temporary hold on the distribution of funds or securities from the account of someone age 65 and older, or someone age 18 and older who has a mental or physical impairment that renders the individual unable to protect her own interests. The temporary hold is also allowed, in certain circumstances where the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted, or will be attempted.
Temporary holds are not applicable to transactions in securities.

Question 37

updating client information

Answer 37

The completed form must be sent to the customer within 30 days. After that, account information must be updated no less frequently than once every three years. Anytime the account is amended, an updated form must be sent to the customer within 30 days.

Question 38

regulation S-P

Answer 38

This regulation was enacted by the SEC to protect the privacy of customer information. In particular, the regulation deals with nonpublic personal information. Examples of nonpublic personal information include a customer’s Social Security number, account balances, transaction history, and any information collected through internet cookies. Your firm must provide a privacy notice describing its privacy policies to customers whenever a new account is opened, and annually thereafter.
If your firm reserves the right to disclose to unaffiliated third parties nonpublic personal information, the notice must provide customers a reasonable means to opt out of this disclosure. Reasonable opt out means include providing customers with a form with check-off boxes along with a prepaid return envelope, providing an electronic means to opt out for customers who have agreed to the electronic delivery of information, and providing a toll-free telephone number. Asking customers to write a letter to express their disclosure preferences or to opt out would not be considered reasonable under Regulation S-P.
In addition, the regulation embodies the obligation of financial institutions to safeguard customer information as related to all forms of existing and developing technology. For example, this would include, but not be limited to, securing desktop and laptop computers and encrypting email.

Question 39

customer identification program

Answer 39

Under provisions of the USA PATRIOT Act, BDs are required to institute a customer identification program (CIP) designed to:
■ verify the identity of any new customer;
■ for an individual, an unexpired government-issued identification such as a drivers license,
passport, military ID, or state ID;
■ for a person other than an individual, documents showing the existence of the entity, such as certified articles of incorporation, a government-issued business license, a partnership agreement, or trust instrument;
■ maintain records of the information used to verify identity; and
■ determine whether the person appears on the Office of Foreign Assets Control (OFAC) list of known or suspected terrorists or terrorist organizations. OFAC regulations prohibit transactions with certain persons and organizations listed on the OFAC website as “Terrorists” and “Specially Designated Nationals and Blocked Persons,” as well as listed embargoed countries and regions. Firms must check this list on an ongoing basis to ensure that potential customers and existing customers are not prohibited persons or entities and are not from embargoed countries or regions before transacting any business with them.
These rules are designed to prevent, detect, and prosecute money laundering and the financing of terrorism.
As part of its CIP, a BD must, before opening an account, obtain the following information at a minimum:
■ Customer name
■ Date of birth (for an individual)
■ Address, which shall be:
— for an individual aresidentialorbusinessstreetaddress,

— for an individual who does not have a residential or business street address, an Army Post Office or Fleet Post Office box number, or the residential or business street address of a next of kin or another contact individual, or
— for a person other than an individual (such as a corporation, partnership, or trust), a principal place of business, local office, or other physical location
■ Social Security number for an individual or Tax ID number for a business entity
■ For a non-U.S. person, one or more of the following: a taxpayer identification number, a passport number and country of issuance, an alien identification card number, or the number and country of issuance of any other government-issued document evidencing nationality or residence and bearing a photograph or similar safeguard. An exception is granted to persons who do not currently have, but who have applied for, a Social Security number. In this instance, the firm must obtain the number within a reasonable period and the account card must be marked “applied for.”
The CIP must include procedures for responding to circumstances in which the BD cannot form a reasonable belief that it knows the true identity of a customer. These procedures should describe:
■ when the BD should not open an account;
■ the terms under which a customer may conduct transactions while the BD attempts to
verify the customer’s identity;
■ when the BD should close an account after attempts to verify a customer’s identity fail; and
■ when the BD should file a suspicious activity report (SAR) in accordance with applicable law and regulation.

Question 40

opening accounts for other members employees

Answer 40

Regulatory bodies have rules and special procedures regarding the establishment of accounts for certain individuals, including:
■ employees of BDs; and
■ spouses or minor children of BD employees.

Question 41

finra requirements

Answer 41

The FINRA rule requires that a person associated with a member, before opening an account or placing an initial securities order with another member, notify the employer and the executing member (where the new account is to be maintained), in writing, of her association with the other member.
Before the account can be opened, the employing FINRA member firm must grant written permission. Prior written consent from the employer is specified within the rule.
Upon written request from the employing member firm, the executing member must supply to the employing member duplicate copies of confirmations, account statements, or any other account information requested.
Exceptions exist when the registered representative is limited to purchasing directly from investment companies, including variable contracts and 529 plans.

Question 42

account authorizations

Answer 42

When opening a brokerage account, the customer opening the account will have final say on investment decisions unless the customer gives someone else that authority, such as a registered representative.

Question 43

Discretionary power

Answer 43

A customer can give discretionary power over his account(s) to someone else only by filing a trading authorization or a limited power of attorney with the BD. No transactions of a discretionary nature can take place without this document on file. Once authorization has been given, the customer is legally bound to accept the decision made by the person holding discretionary authority, although the customer may continue to enter orders on his own. Principal approval is required for a registered representative to have discretionary authority.
In addition to requiring the proper documentation, discretionary accounts are subject to the following rules.
■ Each discretionary order must be identified as such at the time it is entered for execution.
■ An officer or a partner of the brokerage house must approve each order promptly and in
writing, but not necessarily before order entry.
■ A record must be kept of all transactions.
■ No excessive trading or churning may occur in the account relative to the size of the account and the customer’s investment objectives.
To safeguard against the possibility of churning, a designated supervisor or manager must review all trading activity frequently and systematically.

Question 44

an order is discretionary if any of the three as is missing

Answer 44

activity(buy or sell)
Amount(number of shares)
asset(security)

Question 45

a not held order or market not held order

Answer 45

An order that specifies time or price is not discretionary. In other words, if the customer states “buy at the best price or sell at the best time,” discretionary authority is not needed to execute the trade. This type of order is

If a person not named on an account will have trading authority, the customer must file written authorization with the BD giving that person access to the account. This trading authorization usually takes the form of a power of attorney. Two basic types of trading authorizations are full and limited powers of attorney. Both would be canceled upon the death of either party.

Question 46

full power of attorney

Answer 46

A full power of attorney allows someone who is not the owner of an account to:
■ deposit or withdraw cash or securities; and
■ make investment decisions for the account owner.
Custodians, trustees, guardians, and other people filling similar legal duties are often given
full powers of attorney.

Question 47

limited power of attorney

Answer 47

A limited power of attorney allows an individual to have some, but not total, control over an account. The document specifies the level of access the person may exercise. Limited power of attorney, also called limited trading authorization, allows the entering of buy and sell orders but no withdrawal of assets. Entry of orders and withdrawal of assets is allowed if full power of attorney is granted.

Question 48

a durable power of attorney will (in terms of mental incompetence vs death)

Answer 48

survive a declaration of mental incompetence but not death

Question 49

Authorization Records for Negotiable Instruments Drawn From a Customer’s Account

Answer 49

No member or person associated with a member may submit for payment a check, draft, or other form of negotiable paper drawn on a customer’s checking, savings, or similar account, without that person’s express written authorization, which may include the customer’s signature on the negotiable instrument, such as a check. If written authorization is separate from the negotiable instrument, the member must preserve the authorization for a period of three years following termination of the document.

Question 50

approval and Documentation of Changes in Account Name or Designation

Answer 50

Before any customer order is executed, there must be placed upon the order form or other similar record, the name or designation of the account (or accounts) for which such order is to be executed. No change in such account name(s) (including related accounts) or designation(s) may be made unless the change has been authorized by a registered principal.

Question 51

customer information and suitability

Answer 51

Registered representatives must always know their client prior to making any recommendation. A customer’s investment objectives may lead to a recommendation to buy, sell, or hold a security. All recommendations, even a hold recommendation, must be suitable for the client’s situation.

Selecting suitable investments to meet investor needs is an art and a science, and negotiating the difference between what the representative considers suitable and what the customer wants is a legal, ethical, and personal dilemma.
If a customer asks a representative to enter a trade the representative feels is unsuitable, it is the representative’s responsibility to explain why the trade might not be right for the customer. If the customer insists on entering the transaction, the representative should have the customer sign a statement acknowledging that the representative recommended against the trade, and the representative must mark the order ticket unsolicited.
Suitability issues can involve things like the source of the investor’s funding. A customer may wish to liquidate some of the additional equity available on his home in order to invest in a security. The customer must be made aware of the substantial risks inherent in such a step.

Question 52

TRANSFERRING CUSTOMER ACCOUNTS BETWEEN BDs

Answer 52

When a customer—whose securities account is carried by a BD—wants to transfer the account to another BD, the Automated Customer Account Transfer Service (ACATS) automates and standardizes the procedure for the transfer. The customer signs a Transfer Initiation Form (TIF), which is sent to ACATS by the receiving firm. For purposes of this rule, customer authorization could be the customer’s actual signature or an electronic signature.
Once forwarded and received by the carrying firm, it has one business day to validate the securities listed on the TIF or take exception to the transfer instructions. If there are no exceptions, within three business days following validation, the carrying firm must complete the transfer of the account.
No member may interfere with a customer’s request to transfer an account in connection with the change in employment of the customer’s registered representative when the account is not subject to any lien for monies owed by the customer or other bona fide claim.

Question 53

transferring assets from one BD to another

Answer 53

FINRA Rule 2273 requires registered reps, who move to a new firm and try to convince former customers to move with them, to provide educational material outlining things for the customer to consider, including financial incentives that could rise to a conflict of interest for the rep.
The FINRA-prepared educational communication highlights the following potential implications of transferring assets to the new firm:
■ Whether financial incentives received by the representative may create a conflict of interest
■ That some assets may not be directly transferrable to the recruiting firm and, as a result, the customer may incur costs to liquidate and move those assets or account maintenance fees to leave them with his current firm
■ Potential costs related to transferring assets to the recruiting firm, including differences in the pricing structure and fees imposed by the customer’s current firm and the recruiting firm
■ Differences in products and services between the customer’s current firm and the recruiting firm

The rule states that a member who hires a registered person must provide to a former customer (a natural person), in paper or electronic form, the educational communication when:
■ the member, directly or through that registered person, individually contacts the former customer to transfer assets; or
■ the former customer, absent individualized contact, transfers assets to an account assigned to the registered person associated with that member firm.
The communication is required at the time of contact with a former customer by the registered person or the member firm regarding transferring assets.
Contacting the customer may be done with written, electronic, or oral communication. Electronic communication may include a hyperlink directly to the educational communication. If the contact is oral, the member or registered person must notify the former customer that an educational communication that includes important considerations in deciding whether to transfer assets to the member will be provided not later than three business days after the contact.
If a former customer attempts to transfer assets, but no individualized contact with the former customer by the registered person or member occurs before the former customer seeks to transfer assets, the member must deliver the educational communication with the account transfer approval documentation.
The delivery of the communication applies for three months following the date the registered person begins employment or associates with the member.
FINRA Rule 2273 is not applicable when a former customer who is contacted to transfer assets expressly states that she is not interested in transferring assets to the member. If the former customer later decides to transfer assets to the new member without further individualized contact within the period of three months following the date the registered person begins employment with the member, then the educational material is required to be sent. This rule is also not applicable to institutional accounts rather solely for natural persons.

Question 54

retirement plans

Answer 54

An important goal for many investors is to provide themselves with retirement income. Many individuals accomplish this through corporate retirement plans, others set up their own plans, and some have both individual and corporate retirement plans.
There are two basic types of retirement plans in the United States: qualified and nonqualified. Generally speaking, qualified plans allow pretax contributions to be made, while nonqualified plans are funded with after-tax money. Both plans can allow money to grow tax deferred until needed. There are exceptions to these basic characteristics.
Contribution limits for qualified retirement plans vary and are adjusted from time to time.
A taxable distribution from any retirement plan is taxed as ordinary income, never as a capital gain.

Question 55

nonqualified plans

Answer 55

Nonqualified plans may be used to favor certain employees (typically executives) because nondiscrimination rules are not applicable to nonqualified plans.

Question 56

deferred compensation plan

Answer 56

A nonqualified deferred compensation plan is an agreement between a company and an employee in which the employee agrees to defer receipt of current income in favor of payout at retirement. It is assumed that the employee will be in a lower tax bracket at retirement age

(persons affiliated with the company solely as board members are not eligible for these plans because they are not considered employees for retirement planning purposes).
Deferred compensation plans may be somewhat risky because the employee covered by the plan has no right to plan benefits if the business fails. In this situation, the employee becomes a general creditor of the firm. Covered employees may also forfeit benefits if they leave the firm before retirement.
When the benefit is payable at the employee’s retirement, it is taxable as ordinary income to the employee. The employer is entitled to the tax deduction at the time the benefit is paid out.

Question 57

section 457 plans

Answer 57

Section 457 plans are nonqualified retirement plans set up by state and local governments and tax-exempt employers for their employees and independent contractors that work for those entities. They function as deferred compensation plans in which earnings grow tax deferred and all withdrawals are taxed at the time of distribution. Employees may defer up to 100% of their compensation, up to an indexed contribution limit.

Question 58

payroll deduction plan

Answer 58

You might think of a 401(k) plan as a payroll deduction plan. For the FINRA exams, 401(k) plans are considered salary reduction plans, not payroll deduction plans. In exam questions, assume that payroll deduction plans are nonqualified. Also note that 401(k) plans are qualified plans, whereas payroll deduction plans are not.

payroll deduction plans allow employees to authorize their employer to deduct a specified amount for retirement savings from their paychecks. The money is deducted after taxes are paid and may be invested in any number of retirement vehicles at the employee’s option.

Question 59

IRA

Answer 59

IRAs were created to encourage people to save for retirement in addition to other retirement plans in which they participate. The IRA discussed here is sometimes referred to as a traditional IRA. Anyone who has earned income and is under age 701⁄2 is allowed to make an annual contribution of up to an indexed maximum ($6,000 in 2019) or 100% of earned income, whichever is less. Earned income is defined as income from work (e.g., wages, salaries, bonuses, commissions, tips, and, believe it or not, alimony). Income from investments is not considered earned income. If the contribution limit is exceeded, a 6% excess contribution penalty applies to the amount over the allowable portion (unless corrected shortly thereafter as defined by IRS rules).

Question 60

contribution limits

Answer 60

Between January 1 and April 15 (the last legal filing date), contributions and adjustments may be made to an IRA for both the current year and the previous year. Contributions of earned income may continue until age 701⁄2. Contributions are fully deductible, regardless of income, if the investor is not covered by a qualified employer plan or, in the case of a defined benefit plan, is ineligible for coverage. If covered, or, in the case of a defined benefit plan, eligible for coverage, contributions are only deductible if the taxpayer’s AGI falls within established income guidelines (and those amounts are not tested).
Spousal option is available for a spouse who has little or no income. The same amount can be contributed to the individual account and the spousal IRA.
An additional catch-up contribution of $1,000 annually is available for those age 50 and older.

Excess contributions are subject to a 6% penalty. The excess contribution penalty can be avoided by removing the excess contribution (and any earnings) prior to the legal filing date.
Certain investments are not permitted for funding IRAs, including:
■ collectibles (e.g., antiques, gems, rare coins, works of art, stamps);
■ life insurance contracts; and
■ municipal bonds (which are considered inappropriate because the benefit of their tax-free interest is lost within a retirement plan).
Certain investment practices are also considered inappropriate. Those that are not permitted within IRAs or any other retirement plan include:
■ margin account trading;
■ short sales of stock; or
■ uncovered call options.
Covered call writing is permissible because it does not increase risk. This is a hedge strategy; it is combining a stock position with an options contract. It will be covered in detail later in Unit 4. A covered call occurs when an investor sells a call option on stock the investor already owns. If the call is exercised (that means the investor is obligated to sell the stock at the previously agreed upon price—the strike price), the investor simply sells the stock he already owns. For now, just know that a covered call is allowed within IRAs.

Question 61

RMDS

Answer 61

Distributions may begin without penalty once the individual has reached age 591⁄2 and required minimum distributions (RMDs) must begin by April 1 of the year after the individual turns 701⁄2. Distributions before age 591⁄2 are subject to a 10% penalty, as well as regular income tax. The 10% penalty is not applied in the event of:
■ death;
■ disability;
■ purchase of a principal residence by a first-time homebuyer (up to $10,000);
■ education expenses for the taxpayer, a spouse, a child, or a grandchild;
■ medical premiums for unemployed individuals;
■ medical expenses in excess of defined AGI limits; and
■ Rule 72t: substantially equal periodic payments.

If RMDs do not begin by April 1 of the year after the individual turns 701⁄2, a 50% insufficient distribution penalty applies. It is applicable to the amount that should have been withdrawn based on IRS life expectancy tables. Ordinary income taxes also apply to the full amount.

Question 62

Roth IRA

Answer 62

Created in 1997, Roth IRAs allow the same contribution amounts as traditional IRAs. The maximum contribution is 100% of earned income up to an indexed maximum. Both the catch-up provision for those age 50 or older and spousal Roth IRAs are available. Earnings accumulate tax deferred.
Unlike traditional IRAs, contributions are nondeductible (after-tax), contributions can be made to a Roth IRA beyond the age of 701⁄2, and withdrawals from a Roth IRA need not begin at age 701⁄2.
Contributors who have too much AGI may not contribute (number not testable). The owner of a Roth IRA can withdraw contributions at any time without tax or penalty.
If initial contributions to the Roth IRA are less than five years before withdrawal, no matter at what age, earnings withdrawn will trigger ordinary income taxes plus a 10% penalty. Before age 591⁄2, if the account is held five years, contributions and earnings may be withdrawn tax-free in the case of death, disability, or first-time home purchase (up to $10,000). Other than for these exceptions, for the withdrawal of earnings from a Roth IRA to be tax- and penalty-free, the owner must be at least 591⁄2 years old and initial contributions must also
have been made at least five years before the date funds are withdrawn.
The biggest advantage of Roth IRAs is that distributions (including earnings) that satisfy
holding period requirements are income tax-free.

Question 63

Rollover

Answer 63

Individuals may move their investments from one IRA to another IRA or from a qualified plan to an IRA. These movements are known as rollovers or transfers. Assets may also be rolled over into an employer’s retirement plan, provided the employer is willing to accept such deposits.
A rollover occurs when an IRA account owner takes temporary ownership of IRA account funds when moving the account to another custodian. One hundred percent of the funds withdrawn must be rolled into the new account within 60 days or they will be subject to tax and a 10% early withdrawal penalty, if applicable. An individual can make only one rollover from an IRA to another (or the same) IRA in any 365-day period (not per calendar year), regardless of the number of IRAs the individual may own. The limit will apply by aggregating all of an individual’s IRAs, including SEPs (simplified employee pension plans) and SIMPLE IRAs, as well as traditional and Roth IRAs, effectively treating them as one IRA for purposes of the limit. However,
■ trustee-to-trustee transfers between IRAs are not limited; and
■ conversions from traditional to Roth IRAs are not limited.
IRA assets may be directly transferred from an IRA or qualified plan. A transfer occurs when the account assets are sent directly from one custodian to another, and the account owner never takes possession of the funds. There is no limit on the number of transfers that may be made during a 12-month period.

Question 64

Conduit IRA

Answer 64

If a participant in an employer-sponsored qualified plan leaves her place of employment, she may move plan assets to a conduit IRA. If the employee takes possession of the funds through a rollover, 20% of the distribution will be subject to federal withholding tax (withheld).

Question 65

Conversions

Answer 65

The IRS allows individuals to convert money from an IRA to a Roth IRA. Even if an individual’s income is above the allowable limit to contribute to a Roth IRA, the individual can still convert money to a Roth from a (traditional) IRA. However, no additional contributions to the Roth are allowed.
When completing a conversion, all the money that is being converted from the IRA to the Roth IRA will be money that has never been taxed. Therefore, when converting to the Roth IRA, all of the money being converted is subject to ordinary income taxes in the year of the conversion.
In addition, if any RMDs are required in the year of the conversion, the minimum distribu- tion must be taken prior to the conversion.
Generally, converted assets must remain in the Roth IRA for at least five years to avoid penalties and a 10% penalty tax. Distributions from a Roth IRA are tax-free and penalty-free, provided it has been established for at least five years and the recipient meets at least one of the following conditions:
■ Reaches age 591⁄2
■ Passes away
■ Becomes disabled
■ Makes a qualified first-time home purchase
RMDs are not required during the lifetime of the original owner of a Roth IRA.

Question 66

Defined Benefit plan

Answer 66

A defined benefit plan promises a specific benefit at retirement that is determined by a formula involving typical retirement age, years of service, and compensation level achieved.
The amount of the contribution is determined by the plan’s trust agreement and uses actuarial calculations involving investment returns, future interest rates, and other matters. This type of plan may be used by firms that wish to favor older employees; a much greater amount may be contributed for those with only a short time until retirement.

Question 67

Defined contribution plan

Answer 67

are easier to administer. The current contribution amount is specified by the plan’s trust agreement and individual employee accounts are created; however, the benefit that will be paid at retirement is unknown. These plans favor younger employees because they have more time for the money to grow.
Following are two types of defined contribution plans.

Question 68

money purchase plans

Answer 68

are the simplest of the qualified defined contribution plans. Any employer who meets funding requirements may offer such a plan. The employer simply contributes a specified fraction of the employee’s compensation up to an indexed maximum.

Question 69

profit sharing plans

Answer 69

are a popular form of a defined contribution plan. These plans do not require a fixed contribution formula and allow contributions to be skipped in years of low profits.

Question 70

401k

Answer 70

the most popular form of a defined contribution retirement plan, allow the employee to elect to contribute a specific percentage of salary to a retirement account. Contributions are excluded from the employee’s gross income and accumulate tax deferred. Employers may make matching contributions up to a specified percentage of the employee’s contributions. Additionally, 401(k) plans permit certain hardship withdrawals.

Question 71

roth 401k

Answer 71

plans are a relatively new plan option. Roth 401(k) plans are now available as a plan option. A Roth 401(k), like a Roth IRA, requires after-tax contributions but allows tax-free withdrawals, provided the plan owner is at least 591⁄2—though unlike a Roth IRA, there are no income limitations on who may have such a plan. Like a 401(k), it allows the employer to make matching contributions, but the employer’s contributions must be made into a traditional 401(k) account. The employee, who would thus have two 401(k) accounts, may make contributions into either, but may not transfer money from one to the other once it has been deposited. In contrast to a Roth IRA, the account owner must begin withdrawals upon reaching the age of 701⁄2 (unless still working—see Required Beginning Date in the following topic).

Question 72

SEP

Answer 72

are qualified individual retirement plans that offer self-employed persons and small businesses easy-to-administer pension plans. SEPs allow employers to contribute money to SEP IRAs that their employees set up to receive employer contributions

Self-employed individuals may contribute up to a maximum amount each year to a SEP IRA for themselves or employees. Catch-up contributions are generally not allowed for the self-employed person. However, if an employee is enrolled in a SEP and the SEP permits non-SEP IRA contributions be made to the SEP account, they may also make additional catch-up contributions to the SEP account if they are age 50 or older.
Generally, an employer can take an income tax deduction for contributions made each year to each employee’s SEP. Also, the amounts contributed to a SEP by an employer on behalf of an employee are excludable from the employee’s gross income.

Question 73

Savings incentive match plans for employees (SIMPLEs)

Answer 73

are retirement plans for businesses with fewer than 100 employees that have no other retirement plan in place. The employee makes pretax contributions into a SIMPLE up to an annual contribution limit. The employer makes matching contributions. Matching contribution requirements and limits for employers are specified by the IRS and include catch-up contributions for those age 50 and older.

Question 74

Keogh plans

Answer 74

are retirement plans for self-employed people. They were formerly referred to as “H.R. 10 plans” after the law that first allowed unincorporated businesses to sponsor retirement plans. Since the law no longer distinguishes between corporate and other plan sponsors, the term is seldom used. However, you may still see it on your exam.

Question 75

Required beginning date

Answer 75

We have already covered the age at which minimum distributions must begin for IRAs. What about in the case of qualified corporate plans? The term used here is “required beginning date.” A participant must begin to receive distributions from her qualified retirement plan by April 1 of the later of the following years.
■ The first year after the calendar year in which she reaches age 701⁄2.
■ The first year after the calendar year in which she retires from employment with the employer maintaining the plan.

In other words, if you are still working for that employer and are over 701⁄2, minimum
distributions are not required until after you retire.

Question 76

employee stock purchase program

Answer 76

Some publicly-traded companies offer their employees the ability to purchase company stock. There are several ways this can be done, but perhaps the most straightforward method of employee stock ownership can be found in an

Question 77

stock purchase plans

Answer 77

Employee stock purchase plans are essentially a type of payroll deduction plan that allows employees to buy company stock without effecting the transactions themselves. Money is automatically taken out of a participant’s paycheck on an after-tax basis every pay period and accrues in an escrow account until it is used to buy company shares on a periodic basis, such as every six months. These plans are similar to other types of stock option plans in that they promote employee ownership of the company but do not have many of the restrictions that come with more formal stock option arrangements. Plus, they are designed to be somewhat more liquid in nature.
Here are the basics.
■ Contributions should be from 1% to 10% of salary. The contribution is a payroll deduction. This is calculated on pretax salary but taken after-tax (unlike with a 401(k), there is no tax deduction on ESPP contributions).
■ At the end of a “purchase period,” usually every six months, the employer will purchase company stock for participants using contributions during the purchase period. There will be a discount on the purchase price. The employer takes the price of the company stock at the beginning of the purchase period and the price at the end of the purchase period, whichever is lower, and then gives a discount from that price.
■ Participants can sell the purchased stock right away or hold on to the stocks longer for preferential tax treatment.

Question 78

stock options

Answer 78

An employer may also offer stock options that give an employee the right to purchase a specified number of shares of the employer’s common stock at a stated price over a stated time period. Unlike qualified retirement plans, there are no nondiscrimination requirements for these plans. For publicly traded stock, the “strike” price (also called the grant or exercise price) is usually the market price of the stock at the time the option is granted. In most cases, there is a minimum time the employee must remain with the company in order to be able to use the option (the vesting period). The hope of the employee is that the market price of the employer’s stock will increase in value. Then, the employee will be able to purchase the stock by exercising the option (purchasing the stock) at the lower strike price and then sell the stock at the current market price. These are available only to employees of the issuing company. Most states require that the stock option plan be approved by the board of directors.

Question 79

tax sheltered annutites available to who

Answer 79

are available to employees of:
■ public educational institutions;
■ tax-exempt organizations (501(c)(3) organizations); and
■ religious organizations

In general, the clergy and employees of charitable institutions, private hospitals, colleges and universities, elementary and secondary schools, and zoos and museums are eligible to participate if they are at least 21 years old and have completed one year of service.
TSAs are funded by elective employee deferrals. The deferred amount is excluded from the employee’s gross income, and earnings accumulate tax-free until distribution. A written salary reduction agreement must be executed between the employer and the employee.
As with other qualified plans, distributions are 100% taxable, and a 10% penalty is applied to distributions before age 591⁄2.

Question 80

can students participate in TSA

Answer 80

no because the plan is only available to employees

Question 81

Employee Retirement income security act

Answer 81

was established to prevent abuse and misuse of pension funds. ERISA guidelines apply to private-sector (corporate) retirement plans and certain union plans—not public plans like those for government workers. Significant ERISA provisions include the following.

Question 82

participation (ERISA)

Answer 82

This identifies eligibility rules for employees. All employees must be covered if they are 21 years or older and have performed one year of full-time service, which ERISA defines as 1,000 hours or more.

Question 83

Funding(erisa)

Answer 83

Funds contributed to the plan must be segregated from other corporate assets. Plan trustees must administer and invest the assets prudently and in the best interest of all participants. IRS contribution limits must be observed.

Question 84

Vesting (erisa)

Answer 84

Vesting defines when an employer contribution to a plan becomes the employee’s money, such as an employer-matching contribution to a 401(k) plan. ERISA limits how long the vesting schedule can last before the employee is fully vested. Note that an employee is always fully vested in the employee’s own contributions to a plan.

Question 85

communication (erisa)

Answer 85

The plan document must be in writing, and employees must be given annual statements of account and updates of plan benefits.

Question 86

Non discrimination (erisa)

Answer 86

All eligible employees must be treated impartially through a uniformly applied formula.

Question 87

Beneficiaries (erisa)

Answer 87

Beneficiaries must be named to receive an employee’s benefits at death.

Question 88

You may see a question that asks for the type of plans that ERISA regulates.

Answer 88

ERISA applies to private-sector plans (corporate) only. It does not apply to plans for federal or state government workers (public sector plans), nor is it applicable to nonqualified plans.