CSLB General Building (B) — 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
• b.As ordinary income, because all fund distributions are ordinary income
• c.As a long-term capital gain, regardless of how long the investor held the shares✓
• d.It is not taxable until the shares are sold

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.At the lower long-term capital gains rates, if the applicable holding period requirements are met✓
• b.At the investor's ordinary income rate in all cases
• c.Not at all, because the fund already paid tax on them
• 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.Ordinary income tax on the full amount
• b.A long-term capital gain equal to the distribution
• c.An increase in the shareholder's cost basis
• 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.Stays the same, because no new money was added from outside the account
• b.Increases by the $3,000, because the distributions were already taxed✓
• c.Decreases by the $3,000
• d.Is irrelevant, since reinvested shares are always tax free when sold

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 full $4,000 loss is deductible in the current year
• b.The loss is disallowed under the wash sale rule and is added to the basis of the newly purchased shares✓
• c.The loss is permanently forfeited
• 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 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.Average cost, single category
• b.Specific identification of the highest-cost shares
• c.First in, first out✓
• d.Last 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.A taxable event, treated as a sale of the growth fund and a purchase of the bond fund✓
• b.Tax free, because no sales charge was paid
• c.Tax free, because the money never left the fund family
• d.Taxable only if the exchange occurs within one year of purchase

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

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
• b.On a first-in, first-out basis, so principal comes out first
• c.Only when the contract is fully surrendered
• 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.Fully taxable as ordinary income, because there is no after-tax cost basis✓
• b.Taxable only on the earnings portion
• c.Entirely tax free because annuities are tax favored
• d.Taxed at long-term capital gains rates

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

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.529 contributions are never treated as gifts
• b.Contributions are deductible on the federal return
• 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

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.Purchasing power risk, because returns may not keep pace with inflation✓
• b.Credit risk on federally insured deposits
• c.Currency risk from foreign exchange movements
• d.Prepayment risk on the money market fund

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

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.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. 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
• b.A short-term bond fund with a two-year average maturity
• c.A floating rate bank loan fund
• 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.Preservation of capital and liquidity✓
• b.Aggressive capital appreciation
• c.Tax-advantaged long-term growth
• 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 high-yield corporate bond fund inside an IRA
• b.A municipal bond fund, whose income is generally exempt from federal income tax✓
• c.A growth fund that pays no dividends
• d.A money market fund

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