Taxation, Risk, and Evaluating Customer Objectives
The last piece of the Series 6 puzzle is what the customer actually keeps after taxes and what can go wrong along the way. This chapter covers how fund distributions and share sales are taxed, how cost basis is tracked and adjusted, the special ordering rules for annuities, the basics of gift and estate treatment, and the categories of investment risk you must match to a customer's objectives and time horizon.
Taxation of Fund Distributions
A regulated investment company acts as a conduit, passing income through to shareholders who pay the tax. Dividend distributions may be qualified, and therefore taxed at long-term capital gains rates if holding period conditions are met, or non-qualified and taxed as ordinary income; most bond fund income is ordinary. Capital gains distributions are always reported as long-term regardless of how long the shareholder has owned the fund shares, because the fund's holding period controls. Distributions are taxable in the year received even when automatically reinvested. A municipal bond fund's income distributions are generally exempt from federal income tax, but capital gains the fund realizes from selling bonds are fully taxable, a distinction customers routinely miss.
Cost Basis and the Wash Sale Rule
Cost basis is the investor's after-tax investment in the shares, and getting it right is the difference between paying tax once and paying it twice. Basis starts at the purchase price including any sales charge, increases by reinvested distributions that were already taxed, and decreases by return of capital. When shares are sold, the default method is first in, first out unless the shareholder identifies specific shares at the time of sale or elects an average cost method available for fund shares. Losses are disallowed if the investor buys a substantially identical security within 30 days before or after the sale; the disallowed loss is added to the basis of the replacement shares rather than lost. An exchange between two funds in the same family is a sale and a purchase for tax purposes, even though no sales charge is paid.
Annuity, Gift, and Estate Taxation
Non-qualified annuities are funded with after-tax money, so the contract has cost basis. Withdrawals before annuitization come out last in, first out, meaning taxable earnings are distributed first as ordinary income, with a 10% penalty added if the owner is under 59 1/2. Once annuitized, the exclusion ratio splits each payment between a tax-free return of basis and a taxable earnings portion, and payments become fully taxable after basis is recovered. A qualified annuity funded entirely with pre-tax dollars has no basis, so every dollar distributed is ordinary income. On the estate side, inherited securities generally receive a stepped-up basis equal to date-of-death fair market value, while property gifted during life generally carries over the donor's basis. A 529 contribution is a completed gift, and a special election lets a large lump sum be spread over five years of annual exclusions.
Types of Investment Risk
Risk is not a single quantity, and the exam expects you to name the one that dominates a given portfolio. Systematic or market risk affects nearly all securities at once and cannot be diversified away, which is why a broadly diversified equity fund still falls in a bear market. Unsystematic risks such as business risk, industry concentration, and single-issuer default are exactly what diversification addresses. Credit risk drives the behavior of high-yield bond funds. Interest rate risk grows with maturity and duration, so a long-term bond fund falls further than a short-term fund when rates rise. Purchasing power or inflation risk is the quiet threat to conservative portfolios held over decades. Reinvestment, liquidity, currency, political, and legislative risks round out the list.
Matching Objectives to Time Horizon
Every recommendation is an attempt to line up a product's risk and tax profile with a customer's stated objective and the date the money is needed. Preservation of capital and liquidity govern short horizons: a down payment needed in a year belongs in a money market or very short-term fund, because a decline cannot be recovered in time. Growth objectives with long horizons justify equity exposure, since the higher expected return compensates for interim volatility and defends against inflation. Income objectives call for bond or dividend-paying funds, with the account type driving the choice: a high-bracket investor in a taxable account may keep more after tax from a municipal bond fund, while tax-exempt securities are wasted inside an IRA. Speculation is appropriate only for money the customer can afford to lose.
Last updated: July 2026