FINRA Series 6 — All Questions

FINRA's telemarketing rule generally prohibits an unsolicited cold call to a prospective customer's residence:

• a.Before 9:00 a.m. or after 5:00 p.m. in the called party's local time
• b.Before 8:00 a.m. or after 9:00 p.m. in the called party's local time, even when the customer already does business with the firm
• c.Before 8:00 a.m. or after 9:00 p.m. in the firm's local time, unless the customer has an existing relationship with the firm
• d.Before 8:00 a.m. or after 9:00 p.m. in the called party's local time, absent an existing relationship or consent✓

FINRA Rule 3230 restricts unsolicited telemarketing calls to a residence to between 8:00 a.m. and 9:00 p.m. in the called party's local time, not the caller's, and requires honoring do-not-call requests. The restriction is lifted where there is an established business relationship or prior consent, and the limits do not use a 9-to-5 window.FINRA Rule 3230(a)(1)

In an account registered as joint tenants with rights of survivorship, when one owner dies, that owner's interest:

• a.Passes automatically to the surviving owner, outside probate✓
• b.Passes to the deceased owner's estate under the will under state law
• c.Forces liquidation of the account
• d.Reverts to the broker-dealer

Rights of survivorship give the surviving tenant full ownership without probate. Passing to the estate is the tenants-in-common feature; a broker-dealer never takes ownership but will require a death certificate and new paperwork.

Two partners own an account as tenants in common, 60/40. If one partner dies, that partner's share:

• a.Passes to the surviving partner
• b.Passes to the deceased partner's estate under the will or state law✓
• c.Reverts to the broker-dealer
• d.Is split evenly between the survivor and the decedent's heirs by operation of law

Tenants in common allows unequal ownership, and each owner's share passes to the owner's estate, not to the co-tenant. Survivorship is the JTWROS feature and does not apply here.

Which of the following correctly describes an UTMA custodial account?

• a.Gifts are irrevocable, and the custodian must manage the assets solely for the minor's benefit✓
• b.The custodian may pledge the securities as collateral for a personal loan
• c.The assets must be turned over to the minor at age 18 in every state
• d.Gifts may be revoked by the donor at any time before the minor reaches the state's age of majority

A gift into a custodial account is an irrevocable transfer to the minor, and the custodian must manage the property solely for the minor's benefit (Uniform Transfers to Minors Act). The custodian may not pledge it for a personal loan, the donor cannot take the gift back, and the age at which the minor takes control is set by state law, commonly 18 to 21, not a single age.

An UGMA account for a 10-year-old is registered under which taxpayer identification number, and who is the taxpayer?

• a.The broker-dealer's TIN; the firm
• b.The donor's SSN; the donor
• c.The minor's SSN; the minor (subject to the kiddie-tax rules)✓
• d.The custodian's SSN; the custodian

The property belongs to the minor, so the minor's SSN appears on the account and the minor is the taxpayer, though some unearned income may be taxed at the parents' rate under the kiddie tax (Uniform Gifts to Minors Act).

When a custodial-account beneficiary reaches the state's age of majority:

• a.The account must be liquidated
• b.Ownership reverts to the original donor
• c.The custodian may keep managing it indefinitely
• d.The assets are re-registered in the former minor's name and control passes to that person✓

Custodianship ends at the age of majority; the property is retitled to the now-adult beneficiary with full control (Uniform Transfers to Minors Act). Because the original gift was irrevocable, the donor cannot reclaim it.

To open a brokerage account for a trust, the firm must obtain:

• a.Written consent from every trust beneficiary
• b.A court order appointing the trustee, in every case before the firm may accept any instruction on the account
• c.The trust agreement or a certification of trust identifying the trustee and the trustee's powers✓
• d.Only the trustee's Social Security number

The firm needs documentation showing who the trustee is and what authority the trust grants. A personal SSN is insufficient because the trust is a separate legal entity with its own tax ID; court appointment and beneficiary consents are not routinely required.

Before opening a corporate cash account, a broker-dealer must obtain:

• a.A prospectus for the corporation's own securities
• b.A corporate resolution identifying who is authorized to trade for the corporation✓
• c.Two years of audited financial statements
• d.Each officer's personal guarantee

The corporate resolution establishes the entity's authority and names the individuals empowered to act. Officers do not personally guarantee a corporate account, and financial statements are not a prerequisite for a cash account.

A customer wants a representative to choose which funds to buy and when, without checking first. The representative may do so only if:

• a.The customer confirms each trade within one business day
• b.The account exceeds a firm-set minimum balance that the firm requires before granting any trading authority for that customer
• c.The customer gives prior written discretionary authority and a principal approves the account for discretionary trading✓
• d.The representative documents the customer's verbal instruction

Discretion over asset, amount, and timing requires prior written authorization plus firm acceptance and supervisory review (FINRA Rules). Verbal permission is limited to time-and-price discretion for a specific order that day.

For a standard retail cash account, which statement is correct?

• a.Only the customer's signature is required, not a principal's
• b.The representative completes the form and a principal accepts the account; the customer's signature is not a regulatory requirement✓
• c.The form must be signed by the firm's chief compliance officer instead of a principal, and approved before the account can place its first trade
• d.The customer's signature is always required before any trade

For a cash account the representative completes the form and a principal accepts it; the customer's signature is not a regulatory requirement, though firms often collect one. A customer signature is required for margin, discretionary and options accounts, the chief compliance officer need not sign, and the form is a firm record that is not filed with FINRA.

On learning that an individual account holder has died, the representative should:

• a.Cancel open orders, mark the account deceased, and await documents such as a death certificate and letters testamentary✓
• b.Liquidate all positions immediately to protect the estate
• c.Transfer the assets to the named beneficiary the same day
• d.Continue accepting instructions from the customer's spouse

On notice of death the firm freezes the account, cancels open orders, and accepts instructions only from the estate's duly appointed representative after proper documentation (FINRA Rules). Family members have no authority by relationship alone.

When a customer transfers an account between broker-dealers through the automated transfer system, the carrying firm must:

• a.Obtain FINRA approval before releasing the assets
• b.Complete the transfer within 30 calendar days of receiving the instruction
• c.Validate or take exception within three business days, then complete the transfer within five business days
• d.Validate or take exception within one business day and complete the transfer within three business days of validation✓

The automated customer account transfer process requires the carrying firm to validate or take exception within one business day and to complete the transfer within three business days of validation (FINRA Rule 11870). No FINRA approval is needed to release assets, a 30-day window is far too long, and the three-and-five-day timeline is wrong. Assets transfer in kind whenever the receiving firm can hold them.

A firm must send the customer a copy of the account record for verification of the investment profile:

• a.Only when the customer requests it in writing each year
• b.Within 30 days of opening the account and at least once every 36 months thereafter✓
• c.Only when the account is closed, at which point the firm mails a final copy of the profile
• d.Every 12 months without exception

SEC books-and-records rules require an initial verification copy within 30 days of opening and a refresh at least every 36 months, plus updates when the firm learns of a material change (Securities Exchange Act of 1934).

Whether a Traditional IRA contribution is deductible depends primarily on:

• a.The custodian's fee schedule
• b.Whether the taxpayer or spouse is covered by an employer plan and the taxpayer's modified adjusted gross income✓
• c.The investments chosen inside the IRA and whether they generate taxable income during the year for the customer's account
• d.Whether the contribution is made before or after year-end

Anyone with earned income may contribute, but deductibility phases out by income when the taxpayer or spouse is in a workplace plan (Internal Revenue Code). Investment choices and fees do not affect deductibility.

A qualified (tax-free) distribution of Roth IRA earnings requires that:

• a.The owner be at least 65
• b.The account be worth less than $100,000
• c.The distribution be taken in the first year
• d.The account has been open five years and the owner is at least 59 1/2, disabled, or deceased, or is buying a first home within limits✓

A qualified Roth distribution needs both the five-year holding period and a qualifying event, after which earnings are federally tax-free (Internal Revenue Code). Contributions, already taxed, may be withdrawn at any time tax- and penalty-free.

A 45-year-old withdraws $18,000 from a Traditional IRA to remodel a kitchen. The federal tax consequence is:

• a.No tax or penalty, since owners may withdraw at any time
• b.Ordinary income tax on the taxable amount plus a 10% early-distribution penalty✓
• c.A 10% penalty only, with no income tax until age 59 1/2, when the tax-deferred income finally becomes taxable
• d.Tax only, because home improvements are a qualified expense

Distributions before 59 1/2 are included in ordinary income and carry a 10% penalty unless an exception applies; kitchen remodeling is not an exception (Internal Revenue Code). Exceptions include death, disability, qualified education, and up to $10,000 for a first home.

Which of the following statements regarding required minimum distributions (RMDs) is accurate?

• a.Both Traditional and Roth IRA owners must begin RMDs at 73 if born from 1951 through 1959, or at 75 if born later
• b.Roth IRA owners must take RMDs at the Traditional ages, but only on the earnings portion of the Roth balance
• c.Traditional IRA owners must begin RMDs at age 73 or 75, depending on birth year, while original Roth IRA owners face no lifetime RMDs✓
• d.Traditional IRA owners must begin RMDs at age 72 for every birth year, and Roth owners must follow suit

Under SECURE 2.0, the age at which Traditional IRA owners must begin required minimum distributions is 73 for those born from 1951 through 1959 and 75 for those born in 1960 or later (Internal Revenue Code Section 401(a)(9)(C)(v)). Original Roth IRA owners have no lifetime RMDs at all, so Roth and Traditional owners do not follow the same rule, and there is no earnings-only Roth requirement. Age 72 was the starting age before 2023, not the current rule for every birth year.Internal Revenue Code Section 401(a)(9)(C)(v)

Which of the following best describes a 401(k) plan?

• a.An individual retirement account funded solely by the owner outside of work, with no involvement from the employer at any stage
• b.A defined contribution plan funded by employee salary deferrals, often with an employer match✓
• c.A non-qualified deferred compensation plan for executives only
• d.A defined benefit plan that promises a fixed monthly pension

A 401(k) lets employees defer salary on a pre-tax or Roth basis, frequently with an employer match; the benefit depends on contributions and investment results (Internal Revenue Code). A defined benefit plan guarantees a formula-based pension instead.

Eligibility to participate in a 403(b) tax-sheltered annuity plan is limited to employees of:

• a.Self-employed individuals only
• b.Public schools and qualifying 501(c)(3) tax-exempt organizations✓
• c.Federal government agencies exclusively
• d.Any corporation with fewer than 100 employees

Section 403(b) plans serve public-education employees and staff of qualifying tax-exempt organizations such as hospitals and charities (Internal Revenue Code). Federal employees use the Thrift Savings Plan; the self-employed use SEP or solo 401(k) plans.

A key feature of a SEP IRA is that:

• a.Contributions are made after tax and grow tax-free like a Roth, with no current tax deduction available to the employer
• b.The plan requires annual actuarial certification
• c.Contributions are made by the employer into IRAs established for eligible employees✓
• d.Only employees may contribute, through salary reduction

A simplified employee pension is funded by employer contributions deposited into each eligible employee's own IRA (Internal Revenue Code). Salary deferral is the 401(k)/SIMPLE mechanism, and no actuary is needed for this defined-contribution plan.

For what type of employer is a SIMPLE IRA intended?

• a.Employers with up to 500 employees that want to fund the plan entirely with employer contributions
• b.Self-employed individuals with no employees, funded entirely by the owner
• c.Small employers, generally those with 100 or fewer employees, funded by employee salary reduction plus an employer contribution✓
• d.Public schools and tax-exempt organizations that offer tax-sheltered annuities

A SIMPLE IRA serves small businesses, generally with 100 or fewer employees, combining employee salary deferrals with a required employer match or a 2% nonelective contribution (Internal Revenue Code Section 408(p)). A plan funded only by the employer is a SEP, a sole proprietor with no employees uses an individual 401(k), and tax-sheltered annuities are 403(b) plans.Internal Revenue Code Section 408(p) (26 U.S.C. 408(p))

A customer receives a distribution check from a former employer's 401(k) and wants to move it to an IRA. Which statement is correct?

• a.The customer generally has 60 days to deposit the funds, and a direct trustee-to-trustee transfer avoids withholding and the deadline✓
• b.Funds from a 401(k) can be rolled over only into another employer plan, not into an IRA
• c.The check is paid to the customer with no tax withheld, so the customer can deposit the full amount into the IRA within 60 days of receipt
• d.The customer has 90 days to deposit the funds before the distribution becomes taxable

A rollover into an IRA must be completed within 60 days or the distribution becomes taxable, and a plan distribution paid to the participant has 20% mandatory withholding that the customer must replace to roll over the full amount. A direct trustee-to-trustee transfer avoids both. Employer plans can roll into IRAs, the window is 60 days rather than 90, and IRA-to-IRA indirect rollovers are limited to one per 12 months (Internal Revenue Code Sections 402(c) and 408(d)(3)).Internal Revenue Code Sections 402(c) and 408(d)(3) (26 U.S.C. 402(c), 408(d)(3))

A Coverdell Education Savings Account differs from a 529 plan in that the Coverdell:

• a.Allows contributions for a beneficiary of any age, as a 529 plan does
• b.Has a relatively low annual contribution limit and income-based eligibility phaseouts, though qualified withdrawals are tax-free✓
• c.Is a municipal fund security regulated by the MSRB
• d.Limits tax-free withdrawals to college costs, with no use for elementary or secondary school expenses

A Coverdell has a low annual limit ($2,000 per beneficiary) with income-based phaseouts, though qualified withdrawals are tax-free; the 529, not the Coverdell, is the municipal fund security. Contributions generally must stop when the beneficiary turns 18, so it does not accept contributions at any age, and qualified expenses include elementary and secondary school costs as well as college (Internal Revenue Code Section 530).Internal Revenue Code Section 530 (26 U.S.C. 530)

For what purpose does an ABLE account provide tax-advantaged saving?

• a.Retirement income for any adult, with distributions taxed at ordinary rates and no disability requirement
• b.College tuition and fees only, with no other qualified uses
• c.Qualified disability expenses of a beneficiary who became disabled before a specified age, with interests treated as municipal fund securities✓
• d.Disability expenses of a beneficiary who became disabled at any age, with contributions deductible on the federal return

ABLE accounts let eligible individuals whose disability began before the statutory onset age (age 46 for onset on or after January 1, 2026, previously 26) save for qualified disability expenses without losing means-tested benefits; like 529 plans their interests are municipal fund securities under MSRB oversight (Internal Revenue Code Section 529A). They are not general retirement or college-only accounts, there is an onset-age limit, and contributions are not deductible.Internal Revenue Code Section 529A (26 U.S.C. 529A)

Before recommending a variable annuity, a representative must have a reasonable basis grounded in:

• a.The commission the product pays relative to alternatives
• b.The separate account's performance over the past 12 months and the subaccounts' rankings against their peer group reported quarterly
• c.The customer's age, financial situation, tax status, objectives, time horizon, liquidity needs, and risk tolerance✓
• d.The customer's credit score alone

Suitability and best-interest obligations require evaluating the customer's full investment profile before recommending a product (FINRA Rules). Compensation to the representative is a conflict to manage, not a basis for a recommendation.

A 70-year-old must draw income from a $50,000 lump sum within a year and has no other liquid savings. Which recommendation is least suitable?

• a.A deferred variable annuity with a seven-year surrender-charge schedule✓
• b.A short-term investment-grade bond fund with an average maturity under two years
• c.A laddered portfolio of Treasury bills that mature within the next twelve months
• d.A money market fund investing in Treasury and agency securities

Locking the customer's only liquid money into a contract with a seven-year surrender-charge schedule conflicts with a one-year liquidity need and would likely trigger surrender charges. A money market fund, Treasury bills maturing within the year and a short-term bond fund all keep the money accessible and stable enough for a one-year income need (FINRA Rules).

A 30-year-old contributing monthly to a Roth IRA wants maximum long-term growth and plans no withdrawals for 30 years. The most appropriate recommendation is:

• a.A short-term Treasury fund
• b.A single-state municipal bond fund
• c.A money market fund
• d.A diversified equity growth fund✓

A 30-year horizon and a growth objective favor equities, whose higher expected return offsets interim volatility (FINRA Rules). Municipal bonds waste their tax exemption inside a Roth, and cash-like funds risk lagging inflation.

A customer wants to hold six months of living expenses where the money is safe and quickly available. The best match is:

• a.A money market fund✓
• b.A high-yield corporate bond fund
• c.A long-term government bond fund
• d.An aggressive growth fund

Money market funds emphasize preservation of principal and next-day liquidity, fitting an emergency reserve (FINRA Rules). High-yield carries credit risk, growth funds market risk, and long-term bonds significant interest rate risk.

Why is a municipal bond fund generally inappropriate inside a Traditional IRA?

• a.The tax-exempt interest advantage is wasted because IRA earnings are already tax-deferred✓
• b.Municipal bonds are prohibited investments in an IRA
• c.Municipal interest is subject to the alternative minimum tax when held inside an IRA
• d.Holding municipal bonds in an IRA would cause the account to lose its tax-deferred status under IRS rules

Municipal interest is federally tax-exempt, but an IRA already shelters earnings, and distributions are taxed as ordinary income, so the investor pays for a benefit already provided and forgoes the higher taxable yield available elsewhere (Internal Revenue Code). Municipal bonds are not prohibited in an IRA, they do not disqualify the account, and the alternative minimum tax is not the reason.

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)