Series 7 Midterm
A 54-year-old individual invests $25,000 into a nonqualified single premium deferred variable annuity. Five years later, with an account value of $35,000, the investor engages in a Section 1035 exchange into a variable annuity issued by a different insurance company. Four years later, with an account value of $50,000, the investor withdraws $20,000. The tax consequence of the withdrawal is A) $20,000 of ordinary income plus a 10% penalty tax. B) $15,000 of ordinary income, $5,000 nontaxable return of principal. C) $15,000 of ordinary income, $5,000 of long-term capital gain. D) $20,000 of ordinary income.
A partial withdrawal from a nonqualified annuity is taxed on a last-in, first-out (LIFO) basis. That is, the last money in (assumed to be earnings), is the first money out. The cost basis is the original $25,000. The 1035 exchange merely carried that cost basis over and resulted in no current tax on the $10,000 of earnings. When $20,000 is withdrawn, all of it represents the earnings and that is taxed as ordinary income. There is never capital gains taxation on an annuity, and there is no 10% penalty tax because this investor is older than 59½ at the time of the withdrawal. LO 9.d
One of the benefits to a municipality issuing a serial bond is A) lower underwriting costs. B) increased appeal to investors wishing to diversify their portfolios. C) higher rating from the major rating agencies. D) the delayed payback schedule.
A way for a municipal issuer to potentially make the issue more attractive is to diversify by having a range of maturities. That way, the issue will appeal to those investors whose needs might be short term, immediate term, or long term. Serial maturity means that within a single issue, portions of the issue mature at intervals, some short term, others intermediate term, and the balance long term. There is no noticeable difference in costs between issuing serial bonds and term bonds. Ratings are not generally affected by the maturity schedule. With a serial maturity, repayment of principal usually begins within a year or two after issuance—there is no delayed payback. LO 6.a
One of the unique benefits of an employee stock purchase plans is A) participants can sell the stock immediately and any gains are taxed at the favorable long-term rate. B) both the employer and the employee receive a tax deduction. C) the employer compares the price of the stock at the beginning of the purchase period and the end of the period and the purchase is discounted from the lower of the two. D) Money is automatically taken out of a participant's paycheck every pay period.
A wonderful advantage to the employee stock purchase or stock option plan offered by many employers is the opportunity to "play the market." In most cases, the purchase period is every six months and the company will use the employees' escrowed funds to purchase the stock at the lower of the current market price or the price six months earlier. In addition, there is usually a discount applied to that price. Neither receives a tax deduction, and the only way for the employee to receive the long-term capital gains tax rate is to hold the stock more than 12 months. True, the money is automatically taken out of the participant's paycheck every pay period, but there is nothing unique about that—that is the procedure for 401(k) and 403(b) plans. LO 1.h
An investor is concerned about the future of interest rates and wants tax-free income with a long-term maturity based on short-term rates. Which of the following would be the most appropriate recommendation? A) A tax anticipation note (TAN) B) A bond anticipation note (BAN) C) A variable rate demand note (VRDN) D) A municipal auction rate security (ARS)
An ARS is a long-term instrument tied to short-term interest rates and, therefore, would be suitable for someone with a long-term time horizon. As a municipal security, the interest is tax free. Each of the remaining answer choices are short-term notes and do not align with the customer's desires. LO 6.b
One of your clients is a U.S. based taxpayer. The investor owns shares in an ADR and the bank sent a statement showing $500 in dividends paid during the taxable year. The client noticed that only $425 was credited to the account. How would you explain the discrepancy? A) The difference represents the bank's service charge for handling the ADR. B) The difference represents the currency exchange rate. C) The difference represents foreign withholding tax. D) The difference represents a capital loss.
Any tax taken on dividends received from ADRs is taken in the country of origin. This is a foreign withholding tax for U.S. investors. The foreign withholding tax may later be taken as a credit against any U.S. income taxes owed by the U.S. investor. LO 3.g
Trade confirmations to a customer must show yield to call on which of the following bonds? A) 5½%s of 59 at par, callable in two years B) 4½%s of 38 at a 4% basis C) 5½%s of 38 at a 6% basis D) 4½%s of 38 at a 4½% basis
Bond confirmations must disclose the lower of the yield to maturity (YTM) or yield to call (YTC). On a premium bond, the YTC is the lower of the two. The terminology here shows the coupon, the basis (YTM), and the maturity date (and, in one case, the call date). The 4½% bond with a 4% basis is the only bond trading at a premium because the YTM (or basis) is lower than the coupon. Even though the 5½% bond maturing in 2059 is callable relatively soon, because the bond is priced at par, CY, YTM, and YTC are all equal to the coupon (nominal) rate, so the investor will not suffer a loss of principal with an early call. LO 6.h
Brown, Wilson, and Osman (BWO) is a law firm organized as a general partnership. Brown meets with a registered representative with the intention of opening a brokerage account in his name. When it comes to suitability, it would be based on A) each of the employees of the firm. B) each of the partners collectively. C) the firm as a business entity. D) Brown, because he is opening an individual account.
Do not be distracted by the irrelevant information. The account is simply an individual account. LO 1.b
Hayden owns 1,000 shares of XYZ common stock. XYZ announces the sale of additional shares with preemptive rights granted to existing shareholders. The terms of the rights offering require five rights plus $56 to purchase each additional share of XYZ stock. Hayden could choose to A) exercise the rights and acquire 50 shares upon the payment of $2,800. B) exercise the rights and acquire 200 shares upon the payment of $11,200. C) wait about six months to see if the stock price rises. D) have XYZ redeem the rights at their current market value.
Hayden owns 1,000 shares. That means receiving 1,000 rights. If Hayden needs five rights to buy one share, then those 1,000 rights can purchase 200 shares. With a price of $56 per share, it will take $11,200 to make the acquisition. Issuers do not redeem rights; Hayden could sell them in the secondary market if desired. Because rights never go longer than 60 days before expiring, waiting 6 months would not make any sense. LO 3.f
ABC Corporation has outstanding a 10% cumulative preferred stock with a par value of $60 and a market value of $100. Two years ago, ABC omitted its preferred dividend. Last year, it paid a dividend of $5 per share. In order to pay a dividend to common shareholders this year, each preferred share must be paid a dividend of A) $6. B) $13. C) $7. D) $17.
In order for a common dividend to be paid when the issuer has cumulative preferred stock outstanding, the current and previously missed preferred dividends must be satisfied. In this case, the stated dividend is 10% or $6 (10% × par of $60). Two years ago, the shortfall was $6. Last year it was $1. The arrearage of $7 plus the current year's $6, ($13), must be paid before anything can be paid to common. LO 3.e
A member firm is in compliance with Regulation S-P when it provides a retail consumer with A) an annual privacy policy statement. B) a copy of the firm's most recent balance sheet. C) an initial and annual privacy policy statement. D) an initial privacy policy statement.
S-P distinguishes between a consumer and a customer. In the case of a consumer, there is no ongoing relationship. That means that only an initial privacy policy statement is necessary. For a customer, it would be both initial and annual. LO 1.d
What new benefit did the Tax Cuts and Jobs Act of 2017 (TCJA) of 2017 bring to 529 plans effective 2018? A) Qualified withdrawals of up to $10,000 per year to pay for K-12 expenses B) Withdrawals may be made for qualified expenses at certain foreign educational institutions C) Qualified withdrawals of up to $10,000 per year to pay for K-12 tuition D) Tax-deductible contributions of up to $10,000 per year to pay for K-12 tuition
The big change was the ability to use a 529 plan for K-12 expenses. However, the only expense that qualifies is tuition, and there is a maximum limit of $10,000 per year. No contribution to any 529 is tax deductible. The use of the 529 for foreign educational institutions predates the TCJA of 2017 LO 6.g
An investor purchases a TIPS bond with a 4% coupon. If during the first year the inflation rate is 9%, the approximate principal value of the security at the end of that year will be A) $1,045. B) $1,092. C) $1,090. D) $1,040.
The principal value of a TIPS bond is adjusted semiannually by the inflation rate. The exact calculation would be $1,000 x 104.5% x 104.5%, which equals $1,092.025. Each six months, the interest is paid on that adjusted principal and that is why the security keeps pace with inflation. Obviously, the answer must be something a bit higher than $1,090 because of the semiannual compounding. LO 7.a
One of the unusual characteristics of quotes published on U.S. Treasury bills is that A) the quote is in 32nds of a point. B) the bid is higher than the ask. C) the quote represents yield to maturity. D) the ask is higher than the bid.
U.S. Treasury bills are quoted at a discount from the face amount. That is why we have the unusual picture of a bid that is higher than the ask. In this case, that bid number is the percentage discount from the face amount. Just like anything we buy, the larger the discount, the lower the price. So, that higher discount reflects the fact that the actual bid prices is lower than the ask price. It is U.S. Treasury notes and bonds that are quoted in 32nds of a point. LO 7.b
One respect in which the capitalization of a closed-end investment company differs from an open-end investment company is that the closed-end company A) can continuously issue new shares. B) can issue senior securities. C) trades at a price based on supply and demand. D) can invest in senior securities.
Under the Investment Company Act of 1940, only the closed-end company has authorization to issue senior securities (preferred stock and bonds). Open- and closed-end companies can invest in senior securities if appropriate to their investment objectives. Only the open-end company has a continuous offering of new shares (open vs. closed). Although it is true that the price of a closed-end company is based on supply and demand, that is not part of the company's capitalization. Be sure to answer the question being asked. LO 8.b
One of the unique characteristics of a corporate zero-coupon bond is that A) its interest is not taxed until maturity. B) it is a debt obligation of the issuer. C) its duration is equal to its maturity. D) it has the lowest volatility of any debt security of equal quality.
When asked to compute the duration of a zero-coupon bond, the answer is simply the length to maturity. It is the only bond where that is the case. Even though no interest is paid until maturity, the investor receives a tax form each year with the amount of interest to be reported. These bonds have the highest, not lowest, volatility. It is correct that zero-coupon bonds are a debt obligation of the issuer, but what is unique about that? All bonds are debt obligations of the issuer. LO 4.e
If an investor purchased a municipal bond at 103 in the secondary market, which of the following would be a factor in calculating the total dollar amount paid for the bond? A) The coupon rate B) The bond's rating C) The maturity date D) The scale
When computing the total price of a bond purchase, it is necessary to know the accrued interest. The accrued interest cannot be determined without knowing the coupon rate. Neither the bond's rating, the maturity date, nor the scale (covered later in the course) are used in the computation of the total price. LO 6.e
An investor is long 2 JKL October 30 put options. After JKL has a 3:2 stock split, the investor's account will show A) 2 JKL Oct 20 options with a contract size of 150 shares each. B) 3 JKL Oct 20 options with a contract size of 100 shares each. C) 3 JKL Oct 30 options with a contract size of 100 shares each. D) 2 JKL Oct 30 options with a contract size of 150 shares each.
When there is an uneven stock split (or stock dividend), the number of contracts remains the same. It is the number of shares in the contract that is adjusted based on the split. In the case of a 3:2 split, each contract is for 3/2 times 100 shares or 150 shares. The total exercise price remains the same $3,000 as before the split. Dividing $3,000 by 150 shares means that the exchange adjusts the contract's strike price to $20 per share. LO 10.j
