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 and the capital gain is exempt
• b.Both amounts are exempt from federal income tax
• c.The income distribution is generally exempt from federal income tax, while the capital gains distribution is taxable✓
• d.Both amounts are fully taxable as ordinary income

Interest passed through from municipal bonds keeps its federal tax-exempt character, but gains the fund realizes from selling bonds are taxable capital gains. 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

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.On a first-in, first-out basis, so principal comes out first, meaning contributions are recovered 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.Internal Revenue Code

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
• 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.The annual exclusion does not apply to contributions for grandchildren made to the plan for grandchildren as named beneficiaries

529 plans permit front-loading a contribution and electing to treat it as if made ratably over five years, letting the donor apply five years of annual exclusions at once. Contributions are completed gifts, so saying they are never gifts is wrong. There is no federal deduction for 529 contributions, though many states offer one, and the annual exclusion applies to any donee.Internal Revenue Code Section 529

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, since the investor held the shares less than a year, matching the investor's brief holding period in the fund
• b.Ordinary income, like all fund distributions
• c.Not taxable until the shares are sold
• 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 own holding period governs, not the shareholder's (Internal Revenue Code). They are taxable in the year received even if reinvested.

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

• a.At the investor's ordinary income rate in all cases
• 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 tax on the earnings before passing them through to shareholders
• d.Only when the investor sells the fund shares

Dividends meeting the qualified requirements receive the favorable long-term capital gains rates (Internal Revenue Code). Non-qualified dividends and most bond-fund interest are taxed as ordinary income; the shareholder is the taxpayer.

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
• d.A current long-term capital gain equal to the distribution

A return of capital is the investor's own money returned, so it is not currently taxable but lowers basis, increasing the taxable gain on a later sale (Internal Revenue Code). Once basis reaches zero, further returns of capital become taxable gain.

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
• b.Increases by $2,500, because the distributions were already taxed✓
• c.Is irrelevant, since reinvested shares are tax-free when sold because the tax was already collected on the original purchase
• d.Stays the same, because no outside money was added

Reinvested distributions are taxed in the year received, so adding them to basis prevents taxing the same dollars again at sale (Internal Revenue Code). Failing to track reinvestments is a common cause of overstated gains.

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 permanently forfeited
• b.The full $3,000 loss is deductible in the current year, since the repurchase was a separate and independent transaction
• c.The loss is disallowed under the wash-sale rule and added to the basis of the replacement shares✓
• d.Only half the loss is deductible

Repurchasing a substantially identical security within 30 days before or after the sale triggers the wash-sale rule, deferring the loss and adding it to the replacement shares' basis (Internal Revenue Code). Waiting 31 days would preserve the deduction.

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 fully taxable as ordinary income, because all mutual fund distributions are ordinary income passed through to the shareholder
• 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
• d.The interest is taxable and the capital gain is exempt

Interest passed through from municipal bonds keeps its federal tax-exempt character, but gains the fund realizes from selling bonds are taxable capital gains (Internal Revenue Code). Certain private-activity income may also be subject to the AMT.

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 average of cost and market value, the figure the tax rules require for property received from a decedent
• b.$30,000, the decedent's original cost
• c.$70,000, the fair market value at the date of death✓
• d.Zero, because inherited property has no basis

Inherited property generally receives a stepped-up basis equal to its date-of-death fair market value, erasing the unrealized gain for income-tax purposes (Internal Revenue Code). Gifted property during life, by contrast, generally carries over the donor's basis.

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
• b.Does not receive a stepped-up basis; the gain above cost basis is taxed to the beneficiary as ordinary income✓
• c.Passes entirely income-tax free to the beneficiary
• d.Is taxed to the beneficiary at long-term capital gains rates on the gain

Annuity gains are tax-deferred ordinary income and do not get a step-up, so the beneficiary owes ordinary income tax on the amount above the owner's basis (Internal Revenue Code). Inherited appreciated fund shares generally do get a basis step-up.

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
• 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 (Internal Revenue Code). A step-up to fair market value applies to inherited property, not to lifetime gifts.

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 on the federally insured deposits
• c.Prepayment risk on the money market fund as its short-term holdings are repaid and refinanced early
• d.Currency risk on the domestic certificates of deposit

Low-volatility instruments protect principal but historically deliver little real return, so inflation erodes buying power over a long retirement. Insured deposits carry minimal credit risk, and 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
• b.Legislative risk
• c.Credit risk, the possibility that issuers default or are downgraded✓
• d.Currency risk

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; the other risks do not distinguish the two funds.

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 bonds pay more income
• b.Become exempt from federal income tax
• c.Fall, because newly issued bonds offer more attractive yields✓
• d.Stay the same, because the coupon is fixed

Bond prices move inversely to interest rates: older bonds paying lower fixed coupons become less attractive, so their prices fall until yields are competitive. The fixed coupon does not protect the market price, and rate changes do not affect tax status.

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

• a.Any interest-rate increase by the Federal Reserve
• b.A single month 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 indexes 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.

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

• a.Approving the federal budget
• b.Open market operations, the discount rate, and reserve requirements✓
• c.Setting federal income tax rates
• d.Deciding the level of federal program spending

The Federal Reserve manages the money supply and short-term rates through open market operations, the discount rate, and reserve requirements. Tax rates, the budget, and spending are fiscal-policy tools set by Congress and the President.

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

Tax-exempt interest is worth the most to high-bracket investors, so a municipal bond fund can deliver a better after-tax yield than a comparable taxable fund (Internal Revenue Code). A growth fund provides no current income, and placing a taxable fund in an IRA does not serve a taxable-account income need.