Taxation of Investment Vehicles - Review Questions Flashcards
Sidney purchased a long-term bond fund last year. She received a statement at the end of the year that told her a portion of the income she received from the fund is tax-free at the state level. Which of the following types of bonds in her fund may exempt income from state taxes? (Check all that are true.)
1) T-Notes
2) T-Bonds
3) Corporate Bonds
4) High Yield Bonds
1) T-Notes
2) T-Bonds
U.S. government bonds such as treasury notes and bonds and agency bonds are direct obligations of the U.S. government and have income that is exempt from state taxes.
Which of the following types of capital gains are NOT tax exempt?
Choose the best answer.
1) Original Issue Discount
2) Original Issue Premium
3) Market Premium
4) Market Discount
4) Market Discount
Market discounts are not exempt from taxes. When someone purchases a bond in the secondary market at a discount and sells it at a higher price or lets it mature, there is taxable capital gain.
Are dividends subject to taxes if they are reinvested to purchase more shares?
Yes, even when dividends are not paid out in cash, they are taxed as ordinary income.
Janet buys the following round lots of StreamVid, Inc.:
200 shares on January 3, 2006 at $1.50/share
300 shares on September 5, 2009 at $10.50/share
200 shares on April 20, 2021 at $9.50/share
On September 15, 2021 she sold 400 shares at $10/share. What is her cost basis according to the FIFO method?
According to FIFO, she would exhaust the basis of the shares purchased the earliest first:
200 shares at $1.50
200 shares at $10.50
So the gain/loss for this sale was:
200 shares ($10 - $1.50) = $1,700
200 shares ($10 - $10.50) = -$100
Net gain for the sale = $1,600.
Since all 400 shares were held over a year, the $1,600 gain would be subject to long-term capital gains taxes.
Janet buys the following round lots of StreamVid, Inc.:
200 shares on January 3, 2006 at $1.50/share
300 shares on September 5, 2009 at $10.50/share
200 shares on April 20, 2021 at $9.50/share
On September 15, 2021 she sold 400 shares at $10/share.
What would be the cost basis if Janet sells another 200 shares for $10.00 per share, on October 14, 2021? Would the taxes be subject to long-term or short-term capital gains tax?
Once an investor decides on a method, they must stick to that method for holdings of that security. Therefore, the next 200 shares sold will be compared to the remaining shares in Janet’s account.
100 shares ($10 - $10.50) = -$50 that can be used to offset $50 of long-term capital gains. 100 shares ($10 - $9.50) = $50 subject to short-term gains tax.
Janet buys the following round lots of the Mighty growth fund
200 shares on January 3, 2007 at $10/share
300 shares on September 5, 2009 at $15/share
200 shares on April 20, 2021 at $12/share
On September 15, 2021 she sold 400 shares at $10/share. What is her cost basis according to the average cost method?
200 shares at $10 = $2,000
300 shares at $15 = $4,500
200 shares at $12 = $2,400
Total cost = $8,900
Total shares = 700
Average cost per share = $12.71
So the gain/loss for this sale was:
400 shares ($10 - $12.71) = -$1,084
Therefore, Janet had a net loss of = -$1,084
Which of the round lots should Janet identify first to offset the sale of 400 shares at $10/share?
Choose the best answer.
1) 200 shares at $1.50/share
2) 300 shares at $10.50/share
3) 200 shares at $9.50/share
2) 300 shares at $10.50/share
The shares that provide the greatest capital loss or the least capital gains should be the ones identified to be sold first. Therefore, the lot with $10.50 share would be sold first because the lot can provide a $0.50-loss per share. The $9.50/share lot would be next to be sold in order to offset the remaining 100 shares because it only provides $.50 gain rather than the $8.50 gain from the $1.50/share lot.
Would a money fund ever have any personal or distributed capital gains?
No, since money funds try to maintain a $1/share NAV, shareholders cannot sell their shares for more or less than the purchase price they paid for the shares. It is also highly unlikely for a money fund to distribute capital gains.
Your client is designing an educational investment program for her eight-year-old son. She expects to need the funds in about ten years, when her AGI will be approximately $45,000. She wants to invest at least part of the funds in tax-exempt securities. Identify which investment(s) would yield tax-exempt interest on her federal return if the proceeds were used to finance her son’s education.
1) Treasury bills
2) EE bonds
3) GNMA funds
4) Zero-coupon Treasury bonds
2) EE bonds
The interest on Treasury bills, GNMA funds, and zero-coupon Treasury bonds is taxable as income currently. The interest on EE bonds, however, is tax-deferred until the bonds are redeemed or reach final maturity. Also, for EE bonds purchased after 1989, the interest earnings are free from federal income tax if an amount equal to the proceeds is used to pay college tuition and fees. Note that this client’s income is below the phaseout level for this tax advantage. Therefore, EE bonds will best meet this client’s needs.
In May, 1993, Joe Edd bought a tax-exempt original issue discount (OID) bond. Which of the following statements apply?
1) The bond basis increases at a set rate each year.
2) The difference between the maturity value and the original issue discount price is known as the OID.
3) The bond’s earnings are treated as exempt interest income.
4) The bond was issued at a discount to its par value.
All of these statements are correct.
If an investor is in the 28% tax bracket and earns 8.6% on a corporate bond, what is the after-tax yield?
1) 3.6%
2) 6.2%
3) 8.3%
4) 11.9%
5) 18.2%
2) 6.2%
The after-tax yield = before-tax yield * (1 - tax rate) = 8.6 * (1 - 0.28) = 8.6 * 0.72 = 6.192 = 6.2%.
Theresa is planning to retire in twenty years and is considering adding bonds to her tax-deferred retirement account. The type of bond investment that would be best for her is:
1) Mutual fund of municipal bonds from his home state
2) Direct investment in municipal bond from his home state
3) Direct investment in out of state municipal bonds
4) Corporate bonds
4) Corporate bonds
Municipal bonds are not good investments for tax-deferred retirement accounts since the interest is already tax-exempt. Since the yield on the out-of-state municipality is tax exempt for in-state investors, it will probably be lower than the corporate bond.
An investor in the 37% tax bracket who received $70,000 in qualifying dividends has a tax savings of:
1) $ 0
2) $ 11,900
3) $ 14,000
4) $ 25,900
2) $ 11,900
$70,000 × 37% − $70,000 × 20% = $25,900 − $14,000 = $11,900
