FINRA Series 6 — All Questions

An investor bought fund shares four months ago and now receives a capital gains distribution from the fund. How is that distribution taxed?

• a.As a short-term gain, because the investor held the shares less than one year at the time of the capital gains distribution
• b.As a long-term capital gain, regardless of how long the investor held the shares✓
• c.It is not taxable until the shares are sold
• d.As ordinary income, because all fund distributions are ordinary income that are paid out to the investor

Capital gains distributions passed through by a fund are always reported as long-term because the fund's own holding period governs, not the shareholder's. The shareholder's holding period matters only when the shareholder sells the fund shares. Distributions are taxable in the year received even if automatically reinvested.Internal Revenue Code

Qualified dividends distributed by an equity mutual fund to a taxable account are generally taxed:

• a.Not at all, because the fund already paid tax on them at the corporate level before passing them through to shareholders
• b.At the lower long-term capital gains rates, if the applicable holding period requirements are met✓
• c.At the investor's ordinary income rate in all cases, exactly as ordinary short-term trading profits are taxed
• d.Only when the investor eventually sells the fund shares

Dividends that meet the qualified dividend requirements receive the favorable long-term capital gains rates rather than ordinary income treatment. Non-qualified dividends, including most interest income passed through by bond funds, are taxed as ordinary income. A regulated investment company generally pays no entity-level tax on distributed income, so the shareholder is the taxpayer.Internal Revenue Code

A fund makes a distribution characterized as a return of capital. The immediate effect on the shareholder is:

• a.An increase in the shareholder's cost basis
• b.Ordinary income tax on the full amount
• c.A long-term capital gain equal to the distribution, reportable by the shareholder in the current tax year
• d.A reduction in the shareholder's cost basis, with no current tax✓

A return of capital is the investor's own money coming back, so it is not currently taxable but it lowers basis, which increases the taxable gain on a later sale. Once basis reaches zero, further return of capital distributions become taxable gain. Treating it as income or as a current capital gain double counts the tax.Internal Revenue Code

An investor automatically reinvests $3,000 of taxable fund distributions over several years. The effect on cost basis is that basis:

• a.Is irrelevant, since reinvested shares are always tax free when sold
• b.Stays the same, because no new money was added from outside the account
• c.Increases by the $3,000, because the distributions were already taxed✓
• d.Decreases by the $3,000

Reinvested distributions are taxed in the year received, so adding them to basis prevents the same dollars from being taxed again when the shares are sold. Failing to track reinvestments is a common cause of investors overstating their taxable gain. Basis decreases only for return of capital distributions.Internal Revenue Code

An investor sells fund shares at a $4,000 loss on March 10 and buys shares of the same fund on March 25. The result is:

• a.The loss is disallowed under the wash sale rule and is added to the basis of the newly purchased shares✓
• b.Only half the loss is deductible
• c.The loss is permanently forfeited and can never be added to the cost basis of any replacement shares purchased later
• d.The full $4,000 loss is deductible in the current year despite the repurchase of the identical fund shares within days

Repurchasing a substantially identical security within 30 days before or after the sale triggers the wash sale rule, deferring the loss rather than eliminating it. The disallowed amount is added to the basis of the replacement shares, so the benefit is recovered on a later sale. Waiting 31 days would have preserved the current deduction.Internal Revenue Code

Which cost basis method applies to mutual fund shares if the shareholder makes no election?

• a.Last in, first out
• b.Average cost, single category
• c.Specific identification of the highest-cost shares
• d.First in, first out✓

Absent an election, the IRS default for securities including mutual fund shares is first in, first out, which sells the oldest shares first. Shareholders may instead identify specific shares at the time of sale or, for fund shares, elect an average cost method through the fund. LIFO is not an available basis method for these shares.Internal Revenue Code

An investor exchanges shares of a growth fund for shares of a bond fund within the same fund family at net asset value. For tax purposes, this exchange is:

• a.Taxable only if the exchange occurs within one year of purchase of the original growth fund shares
• b.Tax free, because no sales charge was paid
• c.Tax free, because the money never left the fund family
• d.A taxable event, treated as a sale of the growth fund and a purchase of the bond fund✓

An exchange privilege waives the sales charge but does not change the tax character of the transaction: the investor has disposed of one security and acquired another, so any gain or loss is recognized. This is a frequent source of surprise tax bills for customers and should be disclosed before the exchange. Timing affects only whether the gain is short or long term.Internal Revenue Code

A shareholder of a municipal bond fund receives $900 of income distributions and a $500 capital gains distribution. The federal tax treatment is:

• a.The income is taxable as ordinary income, while the capital gains distribution is exempt because it comes from tax-exempt bonds
• b.Both amounts are exempt from federal income tax, because every distribution keeps the exempt character of the bonds
• c.The income distribution is generally exempt from federal income tax, while the capital gains distribution is taxable✓
• d.Both amounts are taxable, because exempt interest passes through only on bonds held directly, not through a fund

A qualifying municipal bond fund can pay exempt-interest dividends, so interest passed through from municipal bonds keeps its federal tax-exempt character (Internal Revenue Code Section 852(b)(5)), but a capital gain dividend is excluded from that treatment and is taxable. Investors often assume a municipal fund is entirely tax free, which is why this distinction matters. Certain private activity bond income may also be subject to the alternative minimum tax.Internal Revenue Code Section 852(b)(5)

Withdrawals of earnings from a non-qualified annuity before annuitization are taxed:

• a.As long-term capital gains at the favorable rate that applies to securities held over a year
• b.Only when the contract is fully surrendered and never on a partial withdrawal of earnings
• c.First-in, first-out, so principal is returned before any earnings
• d.As ordinary income on a last-in, first-out basis, so earnings come out first✓

Non-qualified annuities use LIFO ordering, meaning the taxable earnings are deemed withdrawn before the after-tax principal, and they are taxed at ordinary rates. Annuity gains never receive capital gains treatment because the growth was tax deferred, not invested in a taxable capital asset. Partial withdrawals are taxable when taken, not only at full surrender.IRC Section 72(e)

A variable annuity purchased inside a Traditional IRA with fully deductible contributions is distributed at age 65. The distribution is:

• a.Taxable only on the earnings portion
• b.Entirely tax free because annuities are tax favored when held to at least age 65 inside a retirement account
• c.Fully taxable as ordinary income, because there is no after-tax cost basis✓
• d.Taxed at long-term capital gains rates on the growth above the original contributions

When every dollar went in pre-tax, the contract has no basis, so the entire distribution is ordinary income. An exclusion ratio applies only to non-qualified contracts funded with after-tax money. The tax-deferred wrapper never converts ordinary income into capital gains.Internal Revenue Code

An investor dies owning fund shares purchased for $20,000 that are worth $50,000 on the date of death. The heir's cost basis is generally:

• a.$35,000, the average of cost and market value, as the tax rules require for property received from a decedent
• b.Zero, because inherited property has no basis
• c.$20,000, the decedent's original cost
• d.$50,000, the fair market value at the date of death✓

Inherited property generally receives a stepped-up basis equal to its date-of-death fair market value, wiping out the unrealized appreciation for income tax purposes. Carrying over the decedent's cost or using an average has no basis in the tax rules. Gifted property during life, by contrast, generally carries over the donor's basis.Internal Revenue Code

A donor wants to make a large lump-sum contribution to a 529 plan without using lifetime gift tax exemption. Which feature helps?

• a.Contributions are deductible on the federal return up to the annual gift exclusion
• b.529 contributions are never treated as gifts
• c.A special election allows the contribution to be spread over five years for annual gift tax exclusion purposes✓
• d.An election lets the donor spread the contribution over ten years for annual exclusion purposes

Section 529(c)(2)(B) lets a donor elect to treat a contribution above the annual exclusion as made ratably over five years, so five years of annual exclusions apply at once and lifetime exemption is not used up. The period is five years, not ten. Contributions are completed gifts, so saying they are never gifts is wrong, and there is no federal income tax deduction for 529 contributions, although many states offer one.IRC Section 529(c)(2)(B)

A retiree holds only long-term certificates of deposit and a money market fund. The greatest risk to this portfolio over a 25-year retirement is:

• a.Credit risk on federally insured deposits held at the federally insured issuing bank
• b.Currency risk from foreign exchange movements affecting the domestic certificates of deposit
• c.Prepayment risk on the money market fund as its holdings are refinanced early
• d.Purchasing power risk, because returns may not keep pace with inflation✓

Very low-volatility instruments protect principal but historically deliver little real return, so inflation erodes the portfolio's buying power over a long retirement. Insured deposits carry minimal credit risk, and a domestic portfolio has no meaningful currency exposure. Prepayment risk applies to mortgage-backed securities rather than to money market funds generally.

Which type of risk cannot be reduced by holding a widely diversified equity mutual fund?

• a.Systematic risk, also called market risk✓
• b.Business risk of an individual company, which persists no matter how many holdings the fund adds to the portfolio
• c.Single-issuer default risk
• d.Industry concentration risk, a risk that broad diversification is powerless to remove

Diversification eliminates risks specific to a company or industry, but a broad market decline affects nearly all equities at once, so systematic risk remains. That is precisely why diversified funds still lose value in bear markets. The other three are unsystematic risks that spreading holdings across issuers and sectors addresses.

The dominant risk in a high-yield corporate bond fund compared with a Treasury fund is:

• a.Currency risk, arising from foreign-exchange swings on the fund's overseas bond holdings
• b.Legislative risk, the chance that new tax laws erase the interest advantage of the bonds
• c.Credit risk, the possibility that issuers default or are downgraded✓
• d.Reinvestment risk, the risk that maturing coupons must be reinvested at lower prevailing rates

High-yield issuers have weaker balance sheets, so default and downgrade risk drives their price behavior and explains the higher yield. Treasuries carry essentially no credit risk. Reinvestment, legislative, and currency risks exist in various portfolios but do not distinguish high-yield from Treasury funds.

Interest rates rise sharply. Which fund would most likely experience the largest price decline?

• a.A money market fund holding only overnight government paper that reprices almost constantly
• b.A floating rate bank loan fund whose coupons reset upward as rates climb, cushioning its price
• c.A short-term bond fund with a two-year average maturity, whose modest two-year duration limits its sensitivity to rate moves
• d.A long-term government bond fund with a 20-year average maturity✓

Interest rate risk grows with maturity and duration, so the longest-maturity portfolio suffers the largest price drop when yields rise. Money market and short-term bond funds reprice quickly and move very little. Floating rate instruments adjust their coupons upward, which cushions their prices.

A customer will need a down payment for a home purchase in 14 months. The appropriate primary investment objective is:

• a.Tax-advantaged long-term growth, pursued through a tax-deferred retirement account
• b.Preservation of capital and liquidity✓
• c.Aggressive capital appreciation sought through a portfolio of aggressive growth stocks
• d.Speculation using sector funds

A known expense within roughly a year rules out volatility, because a decline just before the purchase cannot be recovered in time. Growth and speculation both accept short-term losses in exchange for long-run returns the customer will never realize. Time horizon is the controlling suitability factor here.

A customer in a high federal tax bracket wants current income in a taxable account and is comfortable with moderate interest rate risk. Which recommendation best fits?

• a.A municipal bond fund, whose income is generally exempt from federal income tax✓
• b.A money market fund
• c.A growth fund that pays no dividends
• d.A high-yield corporate bond fund inside an IRA

Tax-exempt interest is worth the most to investors in high brackets, so a municipal bond fund can deliver a better after-tax yield than a comparable taxable fund. A growth fund does not provide current income, and a money market fund provides income but with minimal yield and no tax advantage. Placing a taxable high-yield fund in an IRA does not address a customer who wants income in a taxable account now.Internal Revenue Code

A recession is commonly identified by:

• a.A decline in real gross domestic product over two consecutive quarters✓
• b.A single month of rising unemployment reported by the Bureau of Labor Statistics
• c.Any increase in interest rates by the Federal Reserve during a single monthly reporting period
• d.A one-day drop in the stock market of several percentage points in the major indexes

The widely used rule of thumb defines a recession as two consecutive quarters of falling real GDP, reflecting a broad, sustained contraction. A single month of higher unemployment, a rate increase, or a one-day market drop is too brief or narrow to signal a recession. Understanding the business cycle helps match investments to economic conditions.

Monetary policy in the United States is conducted by the Federal Reserve primarily through:

• a.Setting federal income tax rates for both individuals and corporations each year
• b.Open market operations, the discount rate, and reserve requirements✓
• c.Approving the federal budget
• d.Deciding the level of government spending on programs, which the Federal Reserve directs each fiscal year

The Federal Reserve manages the money supply and short-term rates using open market operations, the discount rate, and reserve requirements. Tax rates, the federal budget, and spending levels are fiscal policy tools set by Congress and the President, not the Fed. Distinguishing monetary from fiscal policy is a common exam point.

When market interest rates rise, the prices of existing fixed-rate bonds held by a bond fund generally:

• a.Rise, because higher rates increase the bonds' income paid to the current holders of the bonds
• b.Stay the same, because the coupon is fixed for the life of each bond in the portfolio
• c.Fall, because newly issued bonds offer more attractive yields✓
• d.Become exempt from federal income tax once market rates move above the coupon rate

Bond prices move inversely to interest rates: when rates rise, older bonds paying lower fixed coupons become less attractive, so their prices fall until their yields are competitive. The fixed coupon does not protect the market price, and rate changes have nothing to do with tax status. Longer-maturity bonds fall the most when rates rise.

An investor bought fund shares three months ago and now receives a capital gains distribution from the fund. That distribution is taxed as:

• a.A short-term gain, because the investor held the fund shares for less than one year
• b.Ordinary income, the same treatment as a fund's interest and nonqualified dividend distributions
• c.Not taxable in the year received if the distribution is reinvested in additional shares
• d.A long-term capital gain, regardless of how long the investor held the shares✓

Capital gains distributions passed through by a fund are always long-term because the fund's holding period governs, not the shareholder's (Internal Revenue Code). They are taxable in the year received even if reinvested, so the three-month holding period, ordinary-income treatment and reinvestment deferral are all wrong.Internal Revenue Code Section 852(b)(3) (26 U.S.C. 852(b)(3))

How are qualified dividends paid by an equity mutual fund into a taxable account generally taxed?

• a.At ordinary income rates in all cases, since fund dividends are never treated as qualified
• b.At the lower long-term capital gains rates, if the holding-period requirements are met✓
• c.Not at all, because the fund already paid corporate income tax on the earnings it distributes
• d.At the lower rates only if the dividends are reinvested in additional fund shares

Dividends meeting the qualified requirements, including the holding period, receive the favorable long-term capital gains rates (Internal Revenue Code Section 1(h)(11)). A fund passes its income through and pays no entity-level tax on it, reinvesting does not change the rate, fund dividends can be qualified, and non-qualified dividends and most bond-fund interest are taxed as ordinary income.Internal Revenue Code Section 1(h)(11) (26 U.S.C. 1(h)(11))

A fund distribution characterized as a return of capital has the immediate effect of:

• a.Increasing the shareholder's cost basis
• b.Reducing the shareholder's cost basis, with no current tax✓
• c.Ordinary income tax on the full amount, as with any other fund distribution
• d.A current long-term capital gain equal to the amount distributed, even before basis is used up

A return of capital is the investor's own money returned, so it is not currently taxable but reduces the cost basis, increasing the taxable gain on a later sale (Internal Revenue Code Section 301(c)). Once basis reaches zero, further returns of capital are taxable as gain, so it never raises basis, is not ordinary income, and is not an immediate capital gain.Internal Revenue Code Section 301(c) (26 U.S.C. 301(c))

An investor automatically reinvests $2,500 of taxable fund distributions over several years. The effect on cost basis is that basis:

• a.Decreases by $2,500, because the fund's price fell by that much
• b.Increases by $2,500, because the distributions were already taxed✓
• c.Increases by $2,500, but only once the reinvested shares have been held for more than one year
• d.Stays the same, because no outside money was added

Reinvested distributions are taxed in the year received, so the dollars used to buy the new shares are added to basis; otherwise the same money would be taxed again at sale. Basis does not decrease: the price drop when a fund pays a distribution is offset by the new shares bought with it. The increase is immediate and does not wait for a holding period, and the new shares are a purchase with taxed dollars even though no cash left the account. Failing to track reinvestments is a common cause of overstated gains.IRS Publication 550, Dividends Used To Buy More Stock

An investor sells fund shares at a $3,000 loss on May 5 and buys shares of the same fund on May 20. The result is:

• a.The loss is disallowed for good, with no adjustment to the replacement shares' basis
• b.The full $3,000 loss is deductible this year, because the wash-sale rule does not cover fund shares
• c.The loss is disallowed under the wash-sale rule and added to the basis of the replacement shares✓
• d.The loss is deductible only against capital gains, with any excess carried forward to later years

Buying substantially identical securities within 30 days before or after a sale at a loss triggers the wash-sale rule. Here the repurchase came 15 days after the sale, so the loss is not deductible now; it is added to the basis of the replacement shares, which postpones the deduction and also carries over the holding period. The loss is therefore deferred, not forfeited. The rule covers fund shares as well as stocks, so the claim that it does not apply is wrong, and the capital-loss limits do not come into play because no loss is allowed this year. Waiting 31 days would have preserved the deduction.IRC Section 1091(a)

Absent an election, which cost-basis method applies to mutual fund shares?

• a.Highest cost first
• b.Last in, first out
• c.First in, first out✓
• d.Average cost, double category

The IRS default for securities, including fund shares, is first in, first out, which sells the oldest shares first (Internal Revenue Code). Investors may instead identify specific shares at sale or elect an average-cost method through the fund.

A shareholder of a municipal bond fund receives $1,000 of interest distributions and a $400 capital gains distribution. The federal tax treatment is:

• a.Both amounts are taxable as ordinary income, because a fund that distributes any capital gain loses the exemption on its interest
• b.The interest distribution is generally exempt from federal income tax, while the capital gains distribution is taxable✓
• c.Both amounts are exempt from federal income tax, because the fund holds nothing but tax-exempt municipal bonds
• d.The interest distribution is taxable as ordinary income, while the capital gains distribution is exempt because municipal bonds are the source

A regulated investment company that holds enough municipal bonds can pass through exempt-interest dividends, which keep their federal tax exemption (IRC Section 852(b)(5)). A capital gain dividend is expressly not an exempt-interest dividend, so the $400 gain is taxable even though the fund holds only municipal bonds. Distributing a gain does not cost the fund its ability to pass through exempt interest. The treatment is not reversed either: the interest is the exempt part. Certain private-activity bond interest may still be subject to the alternative minimum tax.IRC Section 852(b)(5)

How are earnings withdrawn from a non-qualified annuity before annuitization taxed?

• a.As ordinary income on a last-in, first-out basis, so earnings come out first✓
• b.As long-term capital gains
• c.On a first-in, first-out basis, so principal comes out first
• d.Only at full surrender, never on partial withdrawals

Non-qualified annuities use LIFO ordering: the taxable earnings are deemed withdrawn before after-tax principal, taxed at ordinary rates (Internal Revenue Code). Partial withdrawals are taxable when taken, and a 10% penalty applies before 59 1/2.

When a non-qualified annuity is annuitized, the exclusion ratio is used to determine:

• a.How the death benefit is split among beneficiaries
• b.What portion of each payment is a tax-free return of the owner's after-tax cost basis✓
• c.The surrender charge remaining each year
• d.The assumed interest rate for the payout phase

Each annuity payment is split between a tax-free recovery of after-tax investment and a taxable earnings portion, set by the exclusion ratio (Internal Revenue Code). Once basis is fully recovered, later payments are fully taxable.

A variable annuity held inside a Traditional IRA funded entirely with deductible contributions is distributed at age 66. The distribution is:

• a.Fully taxable as ordinary income, because there is no after-tax cost basis✓
• b.Entirely tax-free because it is an annuity
• c.Taxed at long-term capital gains rates on the growth
• d.Taxable only on the earnings portion

When every dollar went in pre-tax, the contract has no basis, so the entire distribution is ordinary income (Internal Revenue Code). An exclusion ratio applies only to non-qualified contracts funded with after-tax money.

An investor dies owning fund shares purchased for $30,000 that are worth $70,000 on the date of death. The heir's cost basis is generally:

• a.$50,000, the midpoint between the decedent's cost and the date-of-death value
• b.$30,000, the decedent's original cost carried over to the heir
• c.$70,000, the fair market value at the date of death✓
• d.Zero, since the heir paid nothing

Property acquired from a decedent generally takes a basis equal to its fair market value at the date of death, so the heir's basis is $70,000 and the $40,000 of unrealized gain is never taxed. Carrying over the decedent's $30,000 cost is the rule for lifetime gifts, not inheritance. No averaging of cost and value is allowed, and the heir's basis is not zero merely because nothing was paid for the shares.IRC Section 1014(a)

A non-qualified variable annuity passes to a beneficiary at the owner's death. Compared with inheriting appreciated mutual fund shares, the annuity:

• a.Also receives a full step-up in basis to date-of-death value, just as the fund shares do
• b.Does not receive a stepped-up basis; the gain above cost basis is taxed to the beneficiary as ordinary income✓
• c.Passes to the beneficiary free of income tax, because the owner already paid tax on the annuity's growth
• d.Is taxed to the beneficiary at long-term capital gains rates on the gain, as a sale of fund shares would be

Annuity gains are tax-deferred income in respect of a decedent, and the step-up rule does not apply to that kind of income, so the beneficiary owes ordinary income tax on the amount above the owner's cost. The owner never paid tax on the growth, so it does not pass tax-free, and ordinary income is not converted to capital gain by the transfer. Inherited appreciated fund shares, in contrast, generally do get a basis step-up.IRC Section 1014(c) and 691(a); IRS Publication 575 (death benefit of a deferred annuity)

A parent gifts appreciated fund shares (cost $10,000, current value $25,000) to an adult child during the parent's life. For figuring a future gain, the child's basis is generally:

• a.Zero, since the child paid nothing
• b.$25,000, the value at the date of the gift
• c.$17,500, the average of cost and value
• d.$10,000, the donor's carryover basis✓

Property received by gift generally takes a carryover basis equal to the donor's basis for figuring a later gain, here $10,000. The child's basis is not zero merely because nothing was paid, it is not the $25,000 gift-date value, and it is not an average of cost and value. A step-up to fair market value applies to inherited property, not to lifetime gifts.IRC Section 1015(a)

A retiree holds only long-term certificates of deposit and a money market fund. Over a 25-year retirement, the greatest risk to this portfolio is:

• a.Purchasing power (inflation) risk, because returns may not keep pace with inflation✓
• b.Credit risk, because the banks holding the deposits could fail and the savings would be lost entirely
• c.Interest rate risk, because rising rates would cut the market price of the certificates and the money fund
• d.Currency risk, because the dollar could weaken against other major currencies

Low-volatility instruments protect principal but historically deliver little real return, so inflation erodes buying power over a long retirement. Deposits within the insurance limits carry minimal credit risk. Certificates held to maturity and a money market fund do not lose principal when rates rise, so interest rate risk is not the main threat. A domestic portfolio has no meaningful currency exposure.

A widely diversified equity mutual fund is unable to reduce which type of risk?

• a.Systematic risk, also called market risk✓
• b.Business risk of an individual company
• c.Industry concentration risk
• d.Single-issuer default risk

Diversification removes risks specific to a company or industry, but a broad market decline affects nearly all equities, so systematic risk remains. That is why diversified funds still lose value in bear markets.

The dominant risk in a high-yield corporate bond fund, compared with a Treasury fund, is:

• a.Reinvestment risk, the possibility that coupons must be reinvested at lower rates
• b.Legislative risk, the possibility that a change in tax law cuts the bonds' value
• c.Credit risk, the possibility that issuers default or are downgraded✓
• d.Currency risk, the possibility that exchange rates erode the fund's return

High-yield issuers have weaker balance sheets, so default and downgrade risk drives their price behavior and explains the higher yield. Treasuries carry essentially no credit risk. Reinvestment, legislative and currency risks apply to both kinds of funds, or to neither, and do not explain the difference between them.

If interest rates rise sharply, which of these funds would probably fall the most in price?

• a.A long-term government bond fund with a 20-year average maturity✓
• b.A floating-rate bank-loan fund whose coupons reset upward as rates climb
• c.A money market fund holding overnight government paper
• d.A short-term bond fund with a two-year average maturity

Interest rate risk grows with maturity and duration, so the longest-maturity portfolio suffers the largest price drop when yields rise. Money market and short-term funds reprice quickly, and floating-rate coupons adjust upward, cushioning prices.

If market interest rates rise, what generally happens to the prices of existing fixed-rate bonds held in a bond fund?

• a.Rise, because the existing coupons now look more valuable
• b.Fall, but only for bonds the issuer is able to call
• c.Fall, because newly issued bonds offer more attractive yields✓
• d.Stay the same until maturity, because the coupon rate is fixed

Bond prices move inversely to interest rates: older bonds paying lower fixed coupons become less attractive, so their prices fall until their yields are competitive. The price drop is not limited to callable bonds, and the fixed coupon does not protect the market price, which changes even though the interest paid does not. Higher rates do not make existing coupons more valuable.

Which of the following is the common rule-of-thumb definition of a recession?

• a.Any interest-rate increase by the Federal Reserve
• b.Two consecutive months of rising unemployment
• c.A decline in real gross domestic product over two consecutive quarters✓
• d.A one-day drop of several percentage points in the major stock indexes

The common rule of thumb defines a recession as two consecutive quarters of falling real GDP, reflecting a broad, sustained contraction. A brief or narrow event such as a one-day market drop does not qualify, and neither does a Federal Reserve rate increase. Two months of rising unemployment is a shorter and narrower signal than the GDP test.

The Federal Reserve carries out U.S. monetary policy chiefly by means of:

• a.Setting federal income tax rates and approving the annual budget
• b.Open market operations, the discount rate, and reserve requirements✓
• c.Issuing Treasury securities and setting federal program spending
• d.Setting the prime rate that every bank charges its customers

The Federal Reserve's policy tools include open market operations, the discount rate (discount window) and reserve requirements, along with interest on reserve balances and overnight reverse repurchase operations. The Board set reserve requirement ratios to zero effective March 26, 2020, so today the Fed steers short-term rates mainly with interest on reserve balances and open market operations, but reserve requirements remain one of its listed tools. Tax rates, the budget and spending are fiscal policy set by Congress and the President, the Treasury issues securities, and the prime rate is set by individual banks.

A customer in a high federal tax bracket wants current income in a taxable account and accepts moderate interest rate risk. The best fit is:

• a.A corporate bond fund, since its stated yield is higher than a municipal fund's
• b.A growth stock fund that pays no dividends and defers tax until shares are sold
• c.A municipal bond fund, whose income is generally exempt from federal income tax✓
• d.A Treasury bond fund, whose interest is exempt from state but not federal tax

For an investor in a high federal tax bracket who needs current income from a taxable account, a municipal bond fund can deliver the best after-tax yield because its interest is generally excluded from federal gross income (IRC Section 103(a)). A corporate bond fund's higher stated yield is taxed as ordinary income at the customer's high rate, so after tax it can fall below the municipal fund's yield. A growth fund that pays no dividends defers tax but does not provide the current income the customer wants. Treasury interest is exempt only from state and local tax, so the customer's high federal rate still applies to it.IRC Section 103(a)

A shareholder sells part of a mutual fund holding bought on different dates and does not adequately identify which shares are sold. Setting aside an average-cost election or a custodian's own default method, which cost basis method does the IRS rule apply?

• a.Last in, first out
• b.Average cost, single category
• c.Specific identification of the highest-cost shares
• d.First in, first out✓

When the lot sold is not adequately identified, Treasury Regulation 1.1012-1(c)(1) charges the sale against the earliest lot purchased, which is first in, first out. Average cost is available for fund shares only by election or through the custodian's default method, so it is not the IRS rule for an unidentified sale. Last in, first out is not a permitted method for these shares. Specifically identifying the highest-cost shares works only if the shareholder adequately identifies them at the time of sale.Treas. Reg. 1.1012-1(c)(1)(i); 1.1012-1(e)

A customer in a high federal tax bracket wants current income from a taxable account, is comfortable with moderate interest rate risk, and wants to limit credit risk. Which recommendation best fits?

• a.A municipal bond fund, whose income is generally exempt from federal income tax✓
• b.A Treasury money market fund, whose interest is exempt from federal tax
• c.A high-yield corporate bond fund, whose extra yield outweighs the tax
• d.A growth fund that pays no dividends, deferring any tax on its gains

Tax-exempt interest is worth the most to investors in high brackets, so a high-quality municipal bond fund can deliver a better after-tax yield than a comparable taxable fund, with moderate interest rate risk and limited credit risk. Treasury interest is exempt from state and local tax, not federal tax. A high-yield corporate fund adds credit risk the customer wants to limit and its interest is fully taxable. A growth fund that pays no dividends does not provide the current income the customer wants.Internal Revenue Code Section 852(b)(5)

A mutual fund investor sells part of a position bought in several lots, and neither identifies which shares are being sold nor elects the average-basis method. Which cost-basis method do the tax rules apply?

• a.Highest cost first, so each sale reports the smallest possible gain
• b.Last in, first out, so the newest shares are treated as sold first
• c.First in, first out✓
• d.The average cost of every share in the account, applied without any election

When an investor neither identifies the shares being sold nor elects the average-basis method, the regulations charge the sale against the earliest lot bought, which is first in, first out. Highest cost first and last in, first out are not default methods; they are only possible through specific identification. Average cost is available only by election (and the old double-category variation can no longer be used), so it is not applied automatically.26 CFR 1.1012-1(c)(1); IRS Publication 550 (Special Rules for Mutual Funds)

In one year, an investor has a $12,000 short-term capital loss and a $5,000 long-term capital gain, and no other gains or losses. What is the tax result?

• a.A $3,000 deduction against ordinary income, with $4,000 carried forward✓
• b.A $7,000 deduction against ordinary income, with nothing carried forward
• c.A $3,000 deduction against ordinary income, with $9,000 carried forward
• d.No deduction at all, because losses may only offset capital gains

Short-term and long-term results are netted, so $12,000 of loss against $5,000 of gain leaves a $7,000 net loss. Up to $3,000 may be deducted against ordinary income, and the remaining $4,000 carries forward indefinitely. Losses are not limited to offsetting gains.IRC Section 1211 and 1212; capital loss netting

An investor bought stock on March 15, 2025 and sold it at a gain on March 15, 2026. The gain is:

• a.long-term, because exactly one year had passed by the sale
• b.short-term, unless the stock paid a dividend while held
• c.long-term, because the stock was held across two tax years
• d.short-term, because it must be held more than one year✓

A long-term holding period is more than one year, and the day after purchase starts the count. A sale on the one-year anniversary is still short-term, and a sale on March 16 would be long-term. The number of tax years touched does not matter.IRC Section 1222; holding period

Which statement about the 3.8% net investment income tax is accurate?

• a.It applies to municipal bond interest of taxpayers above the set income thresholds
• b.It applies to wages and salary of taxpayers whose income exceeds set thresholds
• c.It applies to all taxpayers who receive any dividends or interest during the year
• d.It applies to investment income when a taxpayer's income exceeds set thresholds✓

The 3.8% tax applies to the lesser of net investment income or the amount by which modified AGI exceeds a threshold (such as $200,000 for single filers and $250,000 for joint filers). It does not apply to wages, and municipal interest is excluded from net investment income.IRC Section 1411; net investment income tax

For a dividend on common stock to be a qualified dividend, the investor must hold the stock for more than:

• a.More than one year before the ex-dividend date, as for a long-term holding
• b.90 days during the 181-day period beginning 90 days before the ex-dividend date
• c.60 days during the 121-day period beginning 60 days before the ex-date✓
• d.30 days during the 61-day period beginning 30 days before the ex-dividend date

For common stock, qualified dividend treatment requires more than 60 days of holding in the 121-day window around the ex-date. The 90-day and 181-day figures apply to certain preferred stock dividends.IRC Section 1(h)(11); qualified dividends

A resident of a state with an income tax receives interest on Treasury notes. How is the interest taxed?

• a.Exempt from federal income tax, but fully taxed by the state and local governments
• b.Taxed by the federal government and also taxed by the state and local governments
• c.Exempt from federal, state, and local income taxes, like municipal bond interest
• d.Taxed by the federal government, but exempt from state and local income tax✓

Interest on Treasury securities is taxable at the federal level and exempt from state and local income tax. Municipal bond interest has the opposite federal treatment, and is generally exempt from federal tax.State and local taxation of Treasury interest