FINRA Series 6 — All Questions

A New York resident wants income exempt from both federal and New York State income tax. Which fund fits?

• a.A Treasury bond fund, which holds U.S. government bonds
• b.A national municipal bond fund, which holds issuers in many states
• c.A corporate bond fund, which holds investment-grade issuers
• d.A New York municipal bond fund, which holds New York issuers✓

Municipal interest is exempt from federal tax, and it is also exempt from a state's income tax when the bond was issued within that state, so a single-state fund gives a New York resident both. A national fund may pay out income that is taxable by New York, and Treasury interest is federally taxable.Municipal bond funds

An investor in the 22% federal bracket is considering a municipal bond fund yielding 3.9%. The taxable yield that gives the same after-tax return is closest to:

• a.17.7%, found by using 3.9% / 0.22
• b.5.0%, found by dividing 3.9% by 0.78✓
• c.3.0%, found by multiplying 3.9% by 0.78
• d.4.8%, found by adding 22% of 3.9%

Tax-equivalent yield = tax-free yield / (1 - tax bracket) = 3.9% / 0.78 = 5.0%. Adding 22% of the yield gives only 4.8% (a shortcut that understates it), multiplying by 0.78 moves the wrong way, and dividing by 0.22 uses the tax rate itself.Tax-equivalent yield

A fund share was worth $40 at the start of the year and $42 at the end, after paying $2 per share of dividends and capital gains distributions. The total return for the year is:

• a.9.5%, found by dividing the $4 total return by $42
• b.4.8%, found by dividing the $2 rise in price by $42
• c.5%, found by dividing the $2 rise in price by $40
• d.10%, found by dividing the $4 gain plus payouts by $40✓

Total return = (ending value - beginning value + distributions) / beginning value = ($2 + $2) / $40 = 10%. The price change alone leaves out the distributions, and the beginning value is the base.Total return

A fund with an NAV of $19.00 and an offering price of $20.00 pays annual dividends of $1.00 per share. Its current yield is:

• a.10.0%, based on a par value of $10.00
• b.1.0%, based on the $1.00 dividend alone
• c.5.0%, based on the $20.00 offering price✓
• d.5.3%, based on the $19.00 NAV per share

Current yield for a load fund is annual income divided by the public offering price: $1.00 / $20.00 = 5.0%. Using NAV would produce 5.3%, which is a figure for an investor who can buy at NAV. Par value and the bare dollar dividend are not the base.Mutual fund yield

An investor bought 100 fund shares at $10 and later 300 shares at $14, and sells 100 shares at $15. Using the average cost method, the gain is:

• a.$200, because the basis is $13 per share✓
• b.$300, because the basis is $12
• c.$100, because the basis is $14 per share
• d.$500, because the basis is $10 per share

The average cost is ($1,000 + $4,200) / 400 = $13 per share, so the 100 shares sold have a $1,300 basis and the gain is $1,500 - $1,300 = $200. Using the first shares gives $500, using the latest purchase price gives $100, and averaging the two prices ($12) ignores the share counts.Cost basis methods for mutual funds

A donor buys stock for $20,000 and gives it to a child when it is worth $15,000. The child later sells it for $12,000. What is the child's loss?

• a.$8,000, because the basis for a loss is the donor's $20,000 cost
• b.$5,000, because the loss is the $5,000 decline between the cost and the gift
• c.$3,000, because the basis for a loss is the $15,000 value at the gift✓
• d.$0, because the sale price is below both bases, so no loss is recognized

When the value at the gift is below the donor's cost, the recipient uses the donor's cost as basis for a gain and the lower value for a loss. The child sold below $15,000, so the loss is $15,000 - $12,000 = $3,000.Gifted securities; IRC Section 1015

An annuitant invested $60,000 in a fixed annuity with an expected return of $100,000. Each annual payment is $10,000. How much of each payment is excluded from income?

• a.$4,000, because the exclusion ratio is 40%
• b.$6,000, because the exclusion ratio is 60%✓
• c.$0, because annuity payments are all taxable
• d.$10,000 until cost is back, then none

The exclusion ratio is the investment in the contract divided by the expected return: $60,000 / $100,000 = 60%, so $6,000 of each payment is a tax-free return of cost and $4,000 is taxable. Once the investment is recovered, the full payment is taxable.Annuity taxation; exclusion ratio

A stock has a beta of 1.4. If the overall market rises 10%, the stock is expected to:

• a.rise about 7%
• b.rise about 1.4%
• c.rise about 11.4%
• d.rise about 14%✓

Beta measures sensitivity to market movements. A beta of 1.4 implies the stock moves 1.4 times as much as the market, so a 10% market rise suggests a 14% gain. The other results come from dividing by 1.4 or adding 1.4 to 10.Beta

Fund B returned 10% with a standard deviation of 8%, and the risk-free rate is 2%. Fund B's Sharpe ratio is:

• a.1.00, found by dividing the 8% excess return by the 8% deviation✓
• b.0.80, found by dividing the 8% excess return by the 10% total return
• c.1.25, found by dividing the 10% return by 8, ignoring the risk-free rate
• d.4.00, found by dividing the 8% excess return by the 2% risk-free rate

The Sharpe ratio is (return - risk-free rate) / standard deviation = (10 - 2) / 8 = 1.00. It measures excess return per unit of total risk. Leaving out the risk-free rate, dividing by the return, or dividing by the risk-free rate does not match that definition.Risk-adjusted return

A bond fund has an effective duration of 6 years. If interest rates rise by 1 percentage point, the fund's price is expected to:

• a.fall about 60%
• b.fall by about 6%✓
• c.rise by about 6%
• d.fall by about 1%

Duration estimates the percentage price change for each 1% change in rates: 6 years x 1% = about 6%, and the direction is opposite to rates, so prices fall. A 1% change is not the same as a 1% price change.Bond duration

A 6% bond with a $1,000 par value is priced at $950. The current yield is closest to:

• a.6.00%, found by using the coupon rate
• b.5.70%, found by dividing $57 by $1,000
• c.6.84%, found by dividing $65 by $950
• d.6.32%, found by dividing the $60 by $950✓

Current yield = annual interest / current market price = $60 / $950 = 6.32%. The coupon rate, 6%, is based on par value and is unchanged when price falls.Current yield

A bond is purchased at a discount. Which ordering of its yields is correct, from lowest to highest?

• a.Nominal yield, yield to maturity, current yield
• b.Nominal yield, current yield, yield to maturity✓
• c.Current yield, nominal yield, then YTM
• d.Yield to maturity, current yield, nominal yield

For a discount bond, the coupon (nominal) yield is the lowest, current yield is higher because it is measured against a price below par, and yield to maturity is the highest because it also includes the gain to par.Yield relationships

An inverted yield curve means that:

• a.short-term yields are above long-term yields along the curve✓
• b.yields rise at first and then fall off after about ten years
• c.yields are about equal at every maturity along the curve
• d.long-term yields are higher than short-term yields on the curve

An inverted yield curve slopes downward, with short-term rates above long-term rates, and is often viewed as a signal of a weakening economy. A normal curve has long-term rates above short-term rates, and a flat curve has equal rates.Yield curve

Which of these is a leading economic indicator?

• a.The bank prime rate
• b.The unemployment rate
• c.The inflation rate
• d.New building permits✓

Building permits and stock prices tend to change before the economy turns, so they are leading indicators. Unemployment, the consumer price index, and the prime rate follow the economy, which makes them lagging indicators.Economic indicators

An investor holds a TIPS in a taxable account. When the principal rises with inflation, how is the increase taxed?

• a.As income in the year of the increase, though it is paid only at maturity✓
• b.As a capital gain, once the TIPS is sold or matures at the adjusted principal
• c.As income only in the year the TIPS matures and the adjustment is received
• d.As nothing, because the adjustment only reflects inflation and is federally exempt

The inflation adjustment to a TIPS principal is taxable as interest in the year it occurs, although the investor receives it only at maturity or sale. This is phantom income, which is why TIPS are often held in tax-deferred accounts.Treasury inflation-protected securities

During a year, a fund bought $36 million of securities and sold $30 million of securities. Its average net assets were $100 million. The portfolio turnover rate is:

• a.66%, found by dividing the $66 million of total trades by $100 million
• b.36%, found by dividing the $36 million of purchases by $100 million
• c.6%, found by dividing the $6 million difference by $100 million
• d.30%, found by dividing the $30 million of sales by $100 million✓

Portfolio turnover is the lesser of purchases or sales divided by average net assets: $30 million / $100 million = 30%. Using the larger number or adding the two overstates it.Fund portfolio turnover

An investor sells a stock in a taxable account at a loss, and two weeks later buys the same stock in the investor's IRA. What is the tax treatment?

• a.The loss is disallowed, and the IRA's basis rises by the loss
• b.The loss is disallowed, and the IRA's basis is not increased✓
• c.The loss is deferred, and may be used when the IRA stock is sold
• d.The loss is allowed, because an IRA is a separate account

Under Rev. Rul. 2008-5, a purchase of substantially identical securities in the investor's IRA within the wash sale period disallows the loss, and unlike a purchase in a taxable account, the disallowed loss is not added to the IRA's basis, so the loss is permanently lost.IRC Section 1091; wash sales in IRAs

An investor sells a fund at a loss, and 10 days later the investor's spouse buys the same fund in the spouse's own account. The loss is:

• a.allowed, because the purchase was made in a different account name
• b.disallowed, but only if the couple files a joint tax return
• c.allowed, if the spouse files a separate tax return from the investor
• d.disallowed, because the spouse's purchase triggers the wash sale rule✓

The wash sale rule applies when the taxpayer's spouse (or a controlled company) buys substantially identical securities within 30 days before or after the sale. The 30-day window runs on both sides of the sale.IRC Section 1091; wash sales

An investor buys fund shares, receives a $2 per share long-term capital gain distribution, and sells the shares at a loss three months later. How is the loss treated up to the amount of that distribution?

• a.As an ordinary loss, because the fund distributed the gain
• b.As a nondeductible loss, because it falls under the wash sale rule
• c.As a long-term capital loss, despite the short holding period✓
• d.As a short-term capital loss, because of the short holding period

If fund shares held for six months or less are sold at a loss, the loss is treated as long-term to the extent of long-term capital gain distributions received on them. This prevents the investor from turning a long-term gain into a short-term loss.IRC Section 852(b)(4); short-term mutual fund losses

A fund's NAV is $20.00 just before the ex-date. It pays a $1.00 per share capital gains distribution. An investor buys 1,000 shares the day before the ex-date. Which statement is accurate?

• a.The investor owes no tax, because the NAV falls by the same amount as the payment
• b.The investor's cost basis falls by $1,000 when the distribution is paid to the investor
• c.The investor owes tax only if the distribution is paid in cash rather than reinvested
• d.The investor owes tax on the $1,000, though the NAV drops to about $19.00✓

A distribution reduces the NAV by the amount paid, but the investor who bought before the ex-date is still taxed on the distribution, whether it is taken in cash or reinvested. This is why buying shortly before a distribution is a poor idea in a taxable account.Distributions and NAV

A customer inherits stock that the decedent bought for $10,000 and that was worth $60,000 on the date of death. If the customer sells it for $64,000 four months later, the gain is:

• a.$54,000 and short-term, because the heir held it four months
• b.$4,000 and short-term, because the heir held it four months
• c.$4,000 and long-term, because the basis is stepped up✓
• d.$54,000 and long-term, because the decedent held it long enough

Inherited securities take a basis equal to fair market value on the date of death, so the gain is $64,000 - $60,000 = $4,000. Inherited property is automatically treated as long-term, whatever the heir's actual holding period.Inherited securities

A 62-year-old owns a nonqualified variable annuity with a cost basis of $60,000 and a current value of $100,000. She withdraws $15,000 without annuitizing. How much is taxable as ordinary income?

• a.$15,000✓
• b.$9,000
• c.$6,000
• d.$40,000

Nonqualified annuity withdrawals before annuitization follow last-in, first-out treatment: earnings come out first, and the $40,000 of earnings covers the entire $15,000, so all of it is ordinary income. A pro rata calculation would give $6,000, and the $9,000 figure is the basis share under that method, which does not apply. The $40,000 figure taxes the entire gain although only the amount withdrawn is taxed. At 62, no 10% additional tax arises.IRC Section 72(e)

A retiree annuitizes a nonqualified annuity. Her investment in the contract is $60,000, and her expected return is $100,000. Each monthly payment is $1,000. How much of each payment is taxable?

• a.$400✓
• b.$1,000
• c.$600
• d.$0

The exclusion ratio is $60,000 divided by $100,000, or 60%, so $600 of each payment is a tax-free return of basis and $400 is taxable. Using 60% as the taxable portion reverses it. Full taxation applies only to qualified plan payments with no basis. Principal-first treatment is how withdrawals before annuitization are not taxed, and the opposite is true there.IRC Section 72(b)

A nonqualified variable annuity bought for $100,000 is worth $160,000 when the owner dies. The son, as beneficiary, takes a lump sum. How much is taxable to him?

• a.$0, since the basis steps up at death
• b.$60,000, as long-term capital gain
• c.$160,000, as ordinary income
• d.$60,000, as ordinary income✓

Annuity beneficiaries receive no step-up in basis, so the $60,000 of deferred earnings is taxed as ordinary income when received. Step-up is a feature of assets held outside annuities. Annuity earnings are never capital gains. The $100,000 basis is a return of capital and is not taxed again.IRC Section 72

Which exchange does Section 1035 not allow on a tax-free basis?

• a.A life policy for another life policy
• b.A life policy for an annuity contract
• c.A variable annuity for a variable life policy✓
• d.An annuity contract for another annuity contract

Section 1035 allows life to life, life to annuity and annuity to annuity, but never annuity to life insurance, because deferred annuity earnings would then escape ordinary income tax. The other three directions all qualify when the same owner and insured are used.IRC Section 1035

A life insurance owner surrenders a variable life policy with cash value of $80,000. Premiums paid total $50,000, and a $40,000 loan is outstanding. What is the taxable amount?

• a.$0
• b.$80,000
• c.$40,000
• d.$30,000✓

On surrender, the loan is treated as paid out, so the owner is taxed on cash value less premiums paid: $80,000 minus $50,000 is $30,000. Taxing only the loan ignores the basis recovery. Taxing the whole cash value ignores the $50,000 of premiums. Loans escape tax only while the policy remains in force.IRC Section 72(e)

What is the consequence when a life insurance policy fails the seven-pay test and becomes a modified endowment contract?

• a.The policy is canceled by the insurer automatically
• b.Withdrawals are taxed on a first-in, first-out basis
• c.Loans and withdrawals are taxed earnings first, plus 10% before 59½✓
• d.The death benefit becomes taxable income to the beneficiary

A MEC loses the favorable ordering of regular policies: loans and withdrawals come out earnings first and carry a 10% additional tax before 59½. The death benefit remains generally income tax free. Nothing is canceled. First-in, first-out treatment is what regular policies offer, which is what the MEC loses.IRC Section 7702A

In 2026, a beneficiary uses $18,000 from a 529 plan to pay private high school tuition. How is the withdrawal treated?

• a.Qualified, with no dollar limit on the amount
• b.Qualified; K-12 tuition is allowed up to $20,000 a year✓
• c.Nonqualified; only postsecondary costs qualify
• d.Qualified, though capped at $10,000 per beneficiary a year

Beginning in 2026, qualified K-12 tuition withdrawals are capped at $20,000 per beneficiary per year, so $18,000 is within the limit. The $10,000 cap applied before 2026. Treating K-12 as nonqualified is out of date, and an unlimited allowance ignores the cap.IRC Section 529(c)(7)

A 529 account holds $60,000 of contributions and $20,000 of earnings. The owner takes a $10,000 nonqualified withdrawal. What are the tax consequences?

• a.$2,500 of income plus a $250 additional tax✓
• b.$2,500 of income and no additional tax
• c.$10,000 of income plus a $1,000 additional tax
• d.$2,500 of income plus a $1,000 additional tax

Earnings are 25% of the $80,000 account, so $2,500 of the $10,000 withdrawal is earnings. Only earnings are taxed, and the 10% additional tax applies to that $2,500, which is $250. Taxing the whole $10,000 treats basis as income. Leaving out the additional tax ignores the nonqualified-withdrawal penalty, and applying 10% to the whole withdrawal repeats the first error.IRC Section 529(c)(6)

In 2026, with the annual gift tax exclusion at $19,000, what is the most a single donor can contribute to one beneficiary's 529 plan using the five-year election without using lifetime exemption?

• a.$190,000
• b.$100,000
• c.$95,000✓
• d.$19,000

The election spreads a gift over five years, so five times $19,000 is $95,000 for a single donor. A single year's exclusion is only $19,000. The $190,000 figure assumes a married couple splitting gifts. A round $100,000 is not the product of any rule.IRC Section 2503(b); Section 529(c)(2)

Which statement describes the rollover of 529 funds to the beneficiary's Roth IRA?

• a.The 529 must be open 5 years, with no lifetime cap
• b.The 529 must be open 15 years, with no lifetime cap
• c.The 529 must be open 15 years, with a $10,000 lifetime cap
• d.The 529 must be open 15 years, with a $35,000 lifetime cap✓

SECURE 2.0 permits a rollover to the beneficiary's Roth IRA if the 529 has been open 15 years, subject to a $35,000 lifetime cap and the annual IRA contribution limit. A shorter period or no limit would make the provision a bypass of the IRA limits, and $10,000 is the figure for student loan repayment.IRC Section 529(c)(3)(E)

In one year, two grandparents and a parent each contribute $2,000 to a Coverdell account for the same child. What is the excise tax on the excess if it remains in the account for the year?

• a.$0, since each donor has a separate limit
• b.$360, which is 6% of all $6,000
• c.$120, which is 6% of $2,000
• d.$240, which is 6% of the $4,000 excess✓

The limit is $2,000 per beneficiary from all contributors combined, so $4,000 of the $6,000 is excess, and the excise tax is 6% of that, or $240, each year it stays. Taxing $2,000 or $6,000 uses the wrong base. Separate donors do not each get their own limit.IRC Section 530

A Coverdell ESA beneficiary turns 30 with funds still in the account and no special needs. What must happen?

• a.The balance may stay open if the owner pays a 6% excise tax
• b.The account continues tax-free for as long as the owner wishes
• c.Distribute or roll over within 30 days, or face tax and a penalty✓
• d.The balance is forfeited to the plan sponsor immediately

A Coverdell must be distributed within 30 days after the beneficiary reaches 30 unless rolled over to a family member, and an unrolled balance is taxed on earnings with an additional 10%. Indefinite deferral is not permitted. Funds are never forfeited. The 6% excise tax applies to excess contributions, not to leaving an account open.IRC Section 530(d)(8)

A person who becomes disabled at age 45 in 2026 asks about opening an ABLE account. What is the answer?

• a.Ineligible, because onset must be before age 26
• b.Eligible only if a parent owns the account
• c.Eligible, because onset must be before age 46✓
• d.Ineligible, because onset must be before age 40

Beginning in 2026, an ABLE account requires disability onset before age 46, so onset at 45 qualifies. The earlier age 26 limit was expanded. Age 40 was never the rule. The beneficiary can generally own the account, so parental ownership is not a condition.IRC Section 529A

An ABLE account balance rises to $120,000. What happens to the beneficiary's SSI benefit?

• a.Both SSI and Medicaid end immediately and permanently
• b.Nothing changes, since ABLE balances are fully excluded
• c.SSI continues unchanged, but Medicaid ends
• d.SSI cash is suspended over $100,000; Medicaid continues✓

Only the first $100,000 of an ABLE balance is disregarded for SSI, so the cash benefit is suspended above that, while Medicaid eligibility continues. Losing Medicaid is not part of the rule. A full exclusion is not allowed, and the SSI cash payment is affected.IRC Section 529A; Social Security Act

A client was born in 1962. At what age must she begin required minimum distributions from her traditional IRA?

• a.Age 75✓
• b.Age 72
• c.Age 70½
• d.Age 73

Under SECURE 2.0, people born in 1960 or later begin RMDs at age 75. Age 73 applies to those born from 1951 to 1959. Age 72 applied under earlier law, and 70½ applied before that.IRC Section 401(a)(9)

A traditional IRA owner misses part of an RMD, leaving a $4,000 shortfall. The error is not corrected. What is the excise tax?

• a.$0, since the penalty applies to Roth accounts only
• b.$400, which is 10% of the shortfall
• c.$2,000, which is 50% of the shortfall
• d.$1,000, which is 25% of the shortfall✓

The excise tax is 25% of the shortfall, reduced to 10% only if corrected within the correction window, so $1,000 here. Fifty percent was the old rate, replaced by SECURE 2.0. The 10% rate applies only when timely corrected. The penalty applies to traditional IRAs, while Roth IRAs have no owner RMDs.IRC Section 4974

Which statement about a qualified charitable distribution is correct?

• a.It is an itemized deduction and is also taxable income
• b.It cannot count toward the owner's required distribution
• c.Owner must be 73, and the check is made out to the owner first
• d.Owner is at least 70½ and funds go straight from the trustee✓

A QCD requires an owner of 70½ or older and a direct transfer to the charity, which keeps the amount out of income and lets it satisfy the RMD. Requiring age 73 is wrong. Receiving the check first spoils the exclusion. A QCD is excluded from income, not deducted and taxed.IRC Section 408(d)(8)

A 50-year-old owns a Roth IRA with $30,000 of contributions, a $10,000 conversion made years ago, and $20,000 of earnings. She withdraws $25,000. What is the tax result?

• a.The entire $25,000 is taxable as ordinary income
• b.Nothing is taxed, but 10% applies to all $25,000
• c.None, since contributions come out first✓
• d.$8,333 is taxable under a pro rata rule

Roth withdrawals come out in order: contributions, then conversions, then earnings, so the $25,000 is fully contributions and is neither taxed nor penalized. Taxing it all ignores ordering. A pro rata rule is for traditional IRAs with basis. Contributions carry no penalty.IRC Section 408A(d)(4)

A 56-year-old leaves her employer and wants penalty-free access. Which statement is correct?

• a.The 10% tax applies to every distribution, with no exceptions
• b.The exception requires being at least age 62
• c.The plan is exempt, but a rollover IRA loses the exception✓
• d.Distributions from any IRA are exempt from the 10% tax

Separation from service in or after the year turning 55 exempts distributions from that employer's plan, but not from IRAs, including one funded by a rollover. IRAs have their own exceptions. The statement that there are no exceptions is false, and age 62 is not the threshold.IRC Section 72(t)(2)(A)(v)

An investor sells a fund at a loss in a taxable account and 10 days later buys the same fund in her IRA. What is the result?

• a.The loss is disallowed, then added to the IRA basis
• b.The loss is deferred until the fund is sold in the IRA
• c.The loss is disallowed and is never recovered through the IRA✓
• d.The loss is allowed, because the IRA is a separate account

Revenue Ruling 2008-5 treats the IRA purchase as a replacement, so the loss is disallowed, and since an IRA basis does not adjust, the loss never returns. Treating the IRA as separate ignores the ruling. A basis addition and deferral both assume the usual wash sale remedy, which fails because the shares sit in a tax-deferred account.IRC Section 1091; Rev. Rul. 2008-5

An investor buys 100 shares at $50, sells them at $40, and 10 days later buys 100 shares of the same stock at $42. What is the basis of the new shares?

• a.$5,000
• b.$4,200
• c.$5,200✓
• d.$4,000

The $1,000 loss is disallowed and added to the cost of the replacement shares: $4,200 plus $1,000 is $5,200. The raw purchase price of $4,200 ignores the adjustment. The sale proceeds of $4,000 are unrelated. The original $5,000 cost ignores the new purchase.IRC Section 1091

A single taxpayer has modified AGI of $230,000, which includes $50,000 of net investment income. What is her net investment income tax?

• a.$1,140✓
• b.$0
• c.$1,900
• d.$8,740

The tax is 3.8% of the lesser of net investment income ($50,000) or the excess of MAGI over $200,000 ($30,000). Thirty thousand dollars times 3.8% is $1,140. Using the full $50,000 gives $1,900. Using the entire MAGI gives $8,740. The tax applies because MAGI exceeds the threshold.IRC Section 1411

A REIT shareholder receives a distribution that the REIT designates partly as return of capital. How is the return of capital portion treated?

• a.It reduces cost basis and is not taxed until basis is used up✓
• b.It is taxed in full as ordinary income this year
• c.It is taxed this year as a long-term capital gain
• d.It is permanently exempt from tax at every level

A return of capital lowers the shareholder's basis rather than being current income, so tax is deferred until the shares are sold or basis reaches zero. Immediate ordinary income applies to the ordinary portion. Capital gains treatment applies to the capital gain portion. Return of capital is deferred, not permanently exempt.IRC Section 857

A fund's NAV rose from $20.00 to $21.00 during the year, and it paid $1.50 in distributions. What is the total return?

• a.5.0%
• b.7.5%
• c.11.9%
• d.12.5%✓

Total return is the change in NAV plus distributions over the beginning NAV: ($1.00 plus $1.50) divided by $20.00 is 12.5%. Excluding distributions gives 5.0%, and using only distributions gives 7.5%. Dividing by the ending NAV gives 11.9%, which uses the wrong base.

An investor puts $500 a month into a fund for three months at prices of $10, $20 and $10. What is the average cost per share?

• a.$13.33
• b.$12.00✓
• c.$20.00
• d.$10.00

The investor buys 50, 25 and 50 shares, which is 125 shares for $1,500, an average cost of $12.00. The simple average price of $13.33 ignores that more shares were bought at lower prices. Neither the lowest nor the highest price is the average cost.

A tax-exempt municipal bond fund yields 3.5%. For an investor in the 30% federal bracket, what taxable yield is equivalent?

• a.4.55%
• b.5.0%✓
• c.2.45%
• d.3.5%

The tax-equivalent yield is the tax-free yield divided by one minus the bracket: 3.5% divided by 0.70 is 5.0%. Multiplying by 1.30 understates it, and multiplying by 0.70 does the reverse of the correct operation. The bracket determines how much a tax exemption is worth.

A fund pays a capital gain distribution to an investor who bought the shares two months ago. How does the investor report the distribution?

• a.As a long-term gain, regardless of how long the shares were held✓
• b.As a short-term gain, because the shares were held two months
• c.As a non-taxable return of capital
• d.As ordinary income, because it came from the fund

A capital gain distribution is long-term to the shareholder based on how long the fund held the securities, not on the shareholder's own holding period. Treating it as short-term uses the wrong holding period. It is not ordinary income, and it is a taxable distribution of realized gains rather than a return of capital.IRC Section 852(b)(3)

An investor buys 100 fund shares for $2,000 and reinvests $150 of dividends in additional shares. She later sells everything for $2,600. What is her taxable gain?

• a.$2,600
• b.$150
• c.$450✓
• d.$600

Reinvested dividends were taxed when paid, so they add to the cost basis, which becomes $2,150, and the gain is $2,600 less $2,150, or $450. Ignoring the reinvestment gives $600 and taxes the dividends twice. The dividends alone are $150, and the whole proceeds of $2,600 are not the gain.IRC Section 1012; Treas. Reg. 1.1012-1

A fund notifies a shareholder that part of a distribution is a return of capital. What is the tax treatment?

• a.It is taxed as a qualified dividend in the year received
• b.It is taxed as a short-term gain in the year received
• c.It lowers the shareholder's basis and is taxed only once basis reaches zero✓
• d.It is exempt from tax forever and leaves basis unchanged

A return of capital is not taxed when received but reduces the cost basis, which raises the gain at a later sale; once basis hits zero, further amounts are capital gain. It is not a dividend. Leaving basis unchanged would let the shareholder escape tax permanently. It is not a short-term gain.IRC Section 301(c)