Unit 4 - Client Investment Recommendations and Strategies Flashcards Preview

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Flashcards in Unit 4 - Client Investment Recommendations and Strategies Deck (17):

ERISA Section 404(c)

The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that establishes the standards for private pension plans, such as 401(k)s and 403(b)s. Section 404(c) is a specific part of this law that permits employees to direct the investment of their own retirement accounts.

ERISA Section 404 (c) describes a safe harbor for 401(k) plan fiduciaries. Among the requirements is to provide at least three different investment alternatives with a range of risk and provide account access no less frequently than quarterly.

In order to qualify for the safe harbor under 404(c), the portfolio selections must include at least three different asset classes, such as equity, debt, and cash equivalent. All equities or all debt won’t qualify.

ERISA rules only apply to private sector plans. Government or public sector plans are not subject to the Employees Retirement Income Security Act of 1974.


Life Insurance Proceeds

are generally free from income taxes and will be free from estate taxes, if the insured possesses no incidence of ownership. In other words, a beneficiary other than the deceased's estate has been named, and the owner is someone other than the insured.

The proceeds will not be included in Clara's estate.


When looking at an individual's income statement, which of the following would be included:
A) alimony.
B) stocks and bonds.
C) child support.
D) jewelry.


An individual receiving alimony as part of a divorce decree must report that as income for tax purposes. The ex-spouse paying the alimony treats that as a deduction from income. There are two problems here. First, we’re not told which side this individual is on – paying or receiving the alimony. Second, if we are doing a profile for a client, the receipt of child support is considered income in terms of figuring any discretionary income, even though it is not taxed. But, NASAA doesn’t always think of these things so we have to give them the answer the way they want it.


One respect in which an LLC differs from an S corporation is that

There is no limit to the number of investors (members) in an LLC, while current regulations limit the number of investors (shareholders) in an S corporation to 100. The tax treatment is the same and both can be formed with a single owner.


Under ERISA, a pension portfolio manager may engage in writing covered options:
A) only during declining markets.
B) at no time; writing options is too high a risk.
C) under any circumstances.
D)only if it fits with the objectives of the plan.

Writing covered options is appropriate as long as it matches investment objectives. While writing covered calls is sometimes done to generate income, writing uncovered, or naked, calls is not appropriate for a pension plan because of the unlimited risk potential.


Tim earns $30,000 at his employment and is not offered a pension plan. His wife is not currently employed. What is the best way to set up an IRA to give maximum retirement benefits?
A) Set up one IRA for $5,500 or 100%, whichever is less.
B) Set up one joint account for $11,000.
C) Set up separate accounts totaling $11,000.
D) Set up separate accounts for $5,500 each.

Set up separate accounts for $5,500 each.

A one-worker couple can open a spousal IRA. This type of arrangement allows the contribution of a total of $11,000 to the two accounts and no more than $5,500 in either account. Selecting separate accounts totaling $11,000 could imply that one account could exceed $5,500 while the other would be less. IRAs are always individual accounts. The spousal IRA allows contributions on behalf of a nonworking spouse.


Coverdell ESAs

Also called Education IRA

There are income limits that apply to Coverdell ESAs. Single individuals earning more than $110,000 per year are not permitted to open a Coverdell account, and married couples lose the ability to contribute when earnings exceed $220,000. However, there are no income limits restricting who is eligible to open and contribute to a Section 529 college savings plan.

The maximum annual contribution to an Education IRA, better known as a Coverdell ESA, is $2,000 per beneficiary (child). Contributions are not deductible and must cease when the beneficiary reaches age 18. If the accumulated value in the account is not used by age 30, the funds must be distributed and the earnings are subject to income tax and a 10% penalty. Taxes and penalties can be avoided if the account is rolled over into a different Coverdell ESA for another family member.​

The funds grow income tax deferred and, if used for elementary, secondary, or college educational expenses, the earnings are tax free.

In the case of the ESA, on the IRS form used to open the account, it states: “The ‘responsible individual”’ named by the depositor shall be a parent or guardian of the designated beneficiary.” Unless we are told that the grandparent has been appointed as legal guardian, there is a lack of control. And, even then, one thing the “responsible individual” cannot do that the donor to a 529 plan can is take the money back.


UTMA verses Coverdell ESA

Unlike the ESA where couples earning in excess of $220,000 per year are not eligible to contribute, no such ceiling is imposed on those donating or transferring property to an UTMA. Unlike the ESA, where there is a 10% tax penalty on the earnings withdrawn for non-qualified eductional expenses, no such penalty applies to an UTMA. Unlike the ESA which has a $2,000 per year per child limit, there is no limit to the amount that one can give to an UTMA. However, unlike the ESA, where all earnings are tax-free if used for qualified educational expenses, earnings in an UTMA are taxable and, if over a certain amount, might be taxed at the parent's top marginal rate.


QTPs (Section 529 Plans) Qualified Tuition Program

QTPs (Section 529 Plans) allow large contributions reaching as high as $250,000 and above.

If a portion or all of the withdrawal from a QTP is spent on anything other than qualified higher education expenses, the owner/contributor will be taxed at her own tax rate on the earnings portion of the withdrawal.

A special rule under Section 529 allows the donor to load front-end load contributions and avoid paying gift taxes. Five years worth may be used under this method (5 × $14,000 = $70,000). If he remarries, his wife may also consent to gift split, thereby doubling this amount to $140,000. Please note: The annual exclusion was increased to $14,000 effective January 1, 2013.


Which one, if any, of these transactions will be treated as a prohibited transaction under the provisions of the ERISA legislation?
A) A loan between a 401(k) plan and plan participant.
B) The furnishing of office space to a plan trustee for reasonable compensation and fair rental value.
C) An investment adviser using the interest from plan assets to cover the adviser's office expenses.
D) None of these transactions constitute a prohibited transaction under the provisions of the legislation.

An investment adviser, as a fiduciary and disqualified person under the plan, is prohibited from using plan assets in payment of personal obligations (such as outstanding office expenses). Loans from a 401(k) plan to a participant are not prohibited transactions. The plan trustee may rent space from the plan (one of the plan’s assets is an office building).


A client has made both tax-deductible and nondeductible contributions to a traditional IRA. When taking distributions from the IRA:

they are taxed on a pro rata basis.

The portion of the distribution that is nontaxable must be prorated with amounts that are taxable. For instance, if the individual contributed $2,000 in after-tax amounts and $8,000 in pretax amounts, a distribution of $5,000 would be prorated to include $1,000 after-tax and $4,000 in pretax assets.


Employee contributions to a 401(k) plan are subject to:
Social Security taxes.
federal unemployment taxes.
federal income tax withholding.
state income tax withholding.

Social Security taxes.
federal unemployment taxes.

Employee contributions are excluded from taxable income at the time of contributions, which exempts them from income tax, but not from payroll taxes.


Tammy Jones is retiring from her company next month on her 62nd birthday. Her 401(k) has $300,000 and offers her four different mutual funds. After calculating what she will receive from Social Security, she concludes that she will need an additional $500 a month to retain her current lifestyle. Which of the following would be the most appropriate recommendation?
A) Roll the money into a traditional IRA.
B) Leave the money in her current 401(k) account.
C) Take a lump-sum distribution of the entire $300,000.
D) Roll the money into a mutual fund withdrawal plan.

Roll the money into a traditional IRA.

It would benefit Ms. Jones most to roll the money into a traditional IRA. By doing this she would defer paying taxes on the $300,000-something she could not avoid if she took the lump-sum distribution or rolled the money into a mutual fund withdrawal plan. A self-directed traditional IRA account has more investment options than the 4 mutual funds offered in Ms. Jones's 401(k) account.


What is not included in adjusted gross income (AGI)

What is included?

Even though municipal bond interest is reported on line 8b of the 1040, it is specifically not included in AGI.

Salary and commissions
Alimony received from a former spouse


When operating a Keogh plan, a self-employed individual must make contributions for:

full-time employees who are at least 21 years old and have worked for the company for one or more years.

Employees must be covered under a Keogh plan if they are at least 21 years old, have been employed a minimum of one year, and work full-time (at least 1,000 hours per year). Keogh plans do not include employees who are under 21 or have just started working with the employer.


Cost treatment of Donated / Gifted Inherited Securities

When securities are inherited, the heir receives a cost basis calculated as of the deceased party's date of death.

Gifted taxed at donors cost


Mr. Adam Samuels suffers a massive heart attack and dies at the age of 62. As part of his estate, there is an IRA with a current value of $170,000. A review of the IRA documents reveals that Mrs. Eve Samuels, the wife, is the primary beneficiary and their two children have been named as contingent beneficiaries. Eve is 50 years old and does not need the income from the IRA and would like to preserve the IRA for her children to inherit. Which of the following steps would you recommend Mrs. Samuels take?
A) Cash in the IRA because as a spouse of a deceased, she will avoid the 10% tax penalty.
B) Disclaim the IRA and let it pass to the contingent beneficiaries.
C) Execute a rollover into an IRA in her name.
D) Execute a rollover into an inherited IRA.

C) Execute a rollover into an IRA in her name.

This is a highly complicated question and there is room for disagreement. However, if a question similar to this were to appear on your exam, the answer selected is the one that NASAA would mark as the correct one on their test. The key to this question is the word, preserve. By executing a rollover into an IRA in her name, tax deferral of the assets continues and RMDs are not required until after Mrs. Samuels turns 70 ½. Thus, the assets are preserved for at least 20+ years. If she took the distribution, she would not have to pay the penalty tax, but there would be ordinary income tax due and this would not meet her objective of preservation of the IRA. If she disclaimed, the assets would then go to the children, but, they would have to begin taking RMDs based on their life expectancy. Not a bad choice, but the assets are being distributed, not preserved. The benefit of rolling over into an inherited IRA (sometimes called a beneficiary IRA) instead of one in her own name is that she can begin taking distributions right now without the 10% penalty, even though she is only 50. However, the question stated that she did not need the income and, RMDs must begin at the time they would have been required for Mr. Samuels, 12 years earlier than if she chooses to rollover into her own IRA.