Series 6 Study Guide
Post 3 of 13
- 1.1 Reaching out to current and potential customers
- 1.2 Describing to potential and current customers
- 2.1 Provides information about the different account types
- 2.2 Secures customer information/documentation and looks out for suspicious activity
- 2.3 Tries to secure investment profile information regarding the customer
- 2.4 Opening accounts and the supervisory approval
- 3.1 Give customers details regarding strategies for investment
- 3.2 Studies and scrutinizes the investment profiles of customers
- 3.3 Highlights various disclosures to customers about investment products
- 3.4 Keeps customer records
- 4.1 Gives current quotes
- 4.2 Confirmation for customer transactions in line with all regulatory requirements
- 4.3 Tell relevant superior and help with the solution to any customer complaints
Post 3 of 13 in the Series 6 Study Guide
When a registered representative meets a new customer, the beginning point of that relationship will revolve around starting an account for that customer.
Of course, a customer will have certain investing goals and the registered representative has to make sure that they open the right account to help them meet those goals.
In this section, we will specifically look at the types of accounts available, authorizations needed to open them, how to change accounts, how to transfer them, and much more.
The types of basic accounts available to investors
When it comes to brokerage accounts, there are several types of registration options.
To start, let’s look at Individual Accounts.
Also called a single account, there is only one beneficial owner for this account type.
That account owner can:
- Control investments linked to that account
- Ask for securities or cash to be distributed from the account
- Provide permission for third parties to perform various functions on the account
- Specify that a transfer on death (TOD) designation must be added to the account
Just a note on the TOD designation.
Sometimes called POD or payable on death, should the owner of the account die, the TOD provides instructions as to how to distribute the assets in the account.
For estate tax purposes, an account with TOD designations will be considered as part of the owner’s estate but it avoids probate.
Next, we have Joint Accounts.
With this account type, there are co-owners.
That means that two or more people – depending on the number who are named as owners – have control over the account.
To start this account, a joint account agreement will need to be signed between all the co-owners of the account along with a new account form.
With a joint account, anyone who has signed these forms may transact within the account.
When checks are paid into the account, all tenants must endorse the deposit and they must be made payable to all the names of the holders registered for the account.
When it comes to mail sent to the account, for example, account statements, that will only need to be forwarded to one address.
When stock or bond certificates are sold from a joint account, to meet good delivery requirements all tenants will need to sign them.
We spoke of TOD earlier and in some types of joint accounts, this designation can be added.
To do so, however, requires the signature of all the tenants on the TOD itself, and only once the last tenant dies does it come into effect.
As for suitability, a registered representative should always consider the client first, just like they would with any other account type that they open.
So overall, the registered representative is looking at the group as a whole when it comes to suitability.
While any distributions will be in the names of all the owners, any one of them can place trades.
The third account to look at is Joint Tenants With Rights of Survivorship (JTWROS).
With these accounts, when a tenant dies, their interest in the account is passed on to any tenant(s) that are still living.
TOD provisions can be added to these accounts as well.
Once the last tenant dies, the TOD will come into effect.
As to rights on the account, all tenants are designated an equal share.
Another account with more than one owner is a Tenants in Common account.
With a Tenants in Common (TIC) account, when one of the tenants dies, their fractional interest in the account will not go to the surviving tenants.
Instead, it is retained by their estate.
Should one of the tenants either be declared incompetent or die, the cancelation of any outstanding orders or pending transactions must happen immediately.
Until a representative takes control of a portion in place of descendants, like an executor or administrator, or the portion is taken away, the account will be treated as a descendent account.
In terms of ownership portions, in a TIC account, they may not all be equal and in that case, the percentage held by each owner should always be documented.
As far as a TOD designation, unlike the other accounts we have looked into, a TIC account may never have one assigned to it.
The final account to look at the basic accounts is Tenants by the Entirety (TBE).
It’s only people who are legally married that are allowed to open this account.
Working much like a JTWROS account, there are some added extras.
For example, it’s often used for real-estate titles as all owners of this account will be required to sell or take loans against any registered property.
As for a TOD designation, this can be applied to a TBE account.
Types of business accounts available to investors
A registered representative may be approached by a business to open a brokerage account for them.
Let’s look at the various options that are available in this regard.
First, we have accounts for sole proprietors.
For the most part, when dealing with an account for a sole proprietor, a registered representative can treat it in the same manner as they would an individual account.
That’s because a business that is a sole proprietorship has a single owner.
That means individuals will gain all the income and incur all the losses on their accounts.
The major problem with an account like this is linked business debt.
That’s because an owner can lose any securities assets they have, because of the debts their business owes.
As for tax implications related to a sole proprietor account, well these will form part of the owner’s tax return and will need to be reported as such.
When there is more than one owner, a partnership is often a chosen way for people to own a business.
Two or more people can form business partnerships, sometimes called an unincorporated association.
A partnership might look to a broker-dealer to open an account to help save towards retirement but many others could benefit them too, for example, a cash or margin account.
Note that any investment limitations for any member of the partnership must be disclosed should a margin account be opened.
When opening this type of account, it’s critical that from the start, the registered representative establishes which of the partners (if not all of them) are able to make transactions.
This is done through the completion of a partnership agreement.
As for tax, well, partnerships will have to report but not pay taxes.
Any income or losses that the partnership isn’t covered by the partnership at all.
Instead, for tax purposes, these are passed on to the partners.
The only thing a partnership needs to carry out when it comes to tax is to report to the partners and the government the partners’ share in any profits gained or losses incurred.
When any changes have been made to the partnership, it’s necessary to provide an amended partnership agreement to the member firm.
Here are a few more facts about partnerships that are worth knowing:
- A management role is allowed for all partners in a general partnership.
- If the general partnership is in debt, all partners are liable for that debt
- There are two types of partners in a limited partnership. These are general and limited partners.
- The general partners are involved in the day-to-day running of the company and therefore have management authority. With that, however, comes unlimited liability.
- Those partners who only want to invest in the company are seen as limited partners. They won’t be liable for any debt the partnership might incur. They don’t have any management authority. Overall, investment loss is the only real risk that they take on as a limited partner.
The next type of business account we have is for C Corporations.
While C corporations are both taxpaying and legal entities, investors cannot be held liable for any debt these corporations might incur.
That means all liability will fall on the C Corporation itself.
In some cases, a dividend will be paid out when a corporation pays part of its profits to shareholders.
The next example to cover is a Limited Liability Company (LLC).
Investors in this legal entity have a full projection from any liabilities the company may incur, however for tax purposes, an LLC will act in the same way that a partnership does.
That means that LLCs will not pay taxes but as a partnership, any profits that are gained or losses incurred must always be reported.
Instead of the tax implications passed on the owners, as it would be with a partnership, here they are for the investors in the business.
What about S Corporations?
With S Corporations, investors in this legal entity are protected from the company’s liabilities, and much like an LLC, where tax is involved, it will operate as a partnership does.
So again, this means that an S Corporation will not pay taxes.
It is tasked, however, with reporting any profits made or losses incurred.
That means that the investors in an S Corporation will have all tax implications passed on to them.
Next, we have Fiduciary accounts.
When someone controls and manages assets for the account of someone else (the beneficiary), they are known as a fiduciary.
At all times, a fiduciary must run that account and make decisions that will best benefit the owner thereof.
In the case that they don’t do this, a contravention of the fiduciary code has taken place.
An example of this would be buying securities for which they receive a commission and those securities aren’t the best investment that could have been purchased with the beneficiary’s account.
Should this happen and the registered representative handling the fiduciary account is found out, legal ramifications could follow.
When it comes to trust accounts, there are numerous different types.
There are several ways in which trust accounts can be set up, for example, they can be used as retirement plans or as a way to hold assets, either for an individual or a family.
A grantor/trustor will create a trust and any assets they have will be placed in it.
A fiduciary will be appointed to manage the account while a beneficiary of the trust will also be named.
This information can all be found within the trust document.
Trusts can be either revocable or irrevocable:
- With a revocable trust, it may be either revoked or changed by the trustor
- Once an irrevocable trust has been established it can neither be changed by the trustor nor revoked
Trusts can also be set up as a living trust or a descendent trust:
- With a living trust, the trustor will start the trust and then continue to fund it over the course of their life
- With a decedent, trust is funded as in inclusion in the estate settlement of the grantor once they have died.
Let’s move on to Guardianship accounts.
These are set up for minors and act as custodial accounts.
They can be established in two ways, either under the Uniform Transfer to Minors Act (UTMA) or the Uniform Gift to Minors Act (UGMA).
Two parties are involved in the account.
First, there is the minor, who is the beneficiary of the account and then there is the custodian, an adult who controls it.
As for which of the two laws mentioned above pertains to the guardianship account, well that depends entirely on the state the minor lives in.
Most States, however, use UTMA as the law governing these accounts.
If the Series 6 exam talks about these accounts, by default, it will be under UTMA.
One of the most popular forms of trading in the securities industry is trading on margin.
This means that an investor can raise their capital far higher than their current assets.
To do this, they borrow securities, or cash from the broker-dealer they have an account with.
When it comes to margin accounts, you will find two types:
- Long margin accounts
- Short margin accounts
But how do they work and how are they different?
With a loan margin account, customers will pay interest on the money they borrowed to purchase securities.
These interest payments continue right up until the time that the full loan payment is made.
With a short margin account, things work differently.
Here, it’s not money that’s borrowed but stocks.
The customer that borrows them will then sell them short so if the value drops, they will then be able to make a profit.
In a short margin account, it’s imperative that there is an execution of the short sales and that they are all then accounted for.
So where does the customer borrow stocks from for a short margin account?
Well, there are a few options available to them to do so:
- The member firm through which the short sale is carried out
- The margin accounts of other investors of the member firm (this is often the source used)
- Other member firms that hold the stock that they want to buy
- Stock lending firms that specialize in providing stock to margin investors
- Institutional investors
Should a customer look to the margin accounts of other investors of the member firm for their short margin transactions, consent to the loan agreement has to be signed.
Why margin accounts?
Well, there are a few advantages that they can provide to investors:
- Within a margin account, even if they have a low initial cash outlay, they can still purchase more securities by borrowing money to do so
- Within a margin account, by borrowing some of the purchase price they need, the investment can be leveraged
In unfavorable market conditions, the rate of return (or loss) is amplified.
Here are some basic examples of how these market conditions can affect both long and short margin accounts.
- Cash purchase
A customer buys 100 shares of XYZ company at $2 per share and pays $200 for the total purchase.
If the share price increases from $2 to $3, the customer will see a 50% return ($1 increase in share price divided by $2 paid initially =50%)
If the share price drops from $2 to $1, the customer will see a 50% loss ($1 decrease in the share price divided by the $2 paid initially = 50%)
- Margin purchase
A customer buys 100 shares of XYZ company for $2 per share using $100 of their own equity and then borrows from a broker-dealer the other 50% ($100) needed.
If the share price increases from $2 to $3, the customer will see a 100% gain ($100 gain divided by their initial investment of $100 = 100%)
If the share price drops from $2 to $1, the customer will see a 100% loss ($100 loss divided by their initial investment of $100 = 100%)
For broker-dealers, margin accounts have a few advantages:
- When cash is loaned to customers, the interest that the loans generate is an effective form of income for the broker-dealer
- Commissions are increased on margin accounts too because of higher trading capital. That’s because those customers who hold them will often trade larger positions.
While discussing margin accounts, we also need to talk about hypothecation and rehypothecation.
Let’s first see exactly what these terms mean when it comes to margin accounts.
We start with hypothecation.
This is when the securities in a customer’s account are used as margin loan collateral.
For this to happen, when a customer opens a margin account, part of the documentation that they will need to sign will include the hypothecation agreement.
Usually, this will form part of the margin agreement, and once signed, customers are saying hypothecation is approved on their margin account.
Let’s move on to rehypothecation.
This involves a third party, usually a bank but first, some background.
When a broker-dealer lends money to a customer so they can make margin purchases, for the most part, this won’t be their own money.
Instead, they will borrow it from an institution such as a bank.
The stock purchased on margin by the customer will then secure this loan.
In other words, when the margin agreement is signed by the customer with their securities acting as collateral on the loan, they are then repledged or rehypothecated to the bank.
This means they act as collateral on the broker-dealer’s loan from the bank.
All of this is overseen by Regulation U.
Note that a firm’s securities and that of a customer can never be pooled together which is commonly known as commingling.
However, for hypothecation purposes securities from different customers can be commingled as long as both have signed a hypothecation agreement that permits for this to happen.
Which accounts can have a margin feature?
Should the principal approve and all the relevant documentation be completed, individual, joint, and sole proprietor business accounts are allowed to have a margin option.
As for corporate and partnership accounts, well they can open margin accounts too.
There are some prerequisites, however.
The broker-dealer must examine the partnership agreement (for a partnership) or the bylaws/corporate charter in the case of a corporation, specifically to see if they prohibit the use of margin accounts.
If nothing can be found and the relevant documentation is signed, a margin account can be opened for both these account types.
What about trust and fiduciary accounts?
Again, in the case of a trust, the broker-dealer must check the trust agreement to see if there are any objections to the use of margin accounts.
Note, however, that even if there is no indication against a margin account, for a trust to trade with one, there should be a specific entry in the trust agreement saying that it is allowed.
The following accounts (those with limits to contributions) cannot be margin accounts:
- IRAs/other retirement plans
- UTMA/UGMA custodial accounts
You can probably already tell that margin accounts require a fair amount of paperwork.
Let’s look at all the margin account forms that will add the ability to borrow cash or securities to help fund purchases.
First, there is the credit agreement.
In this, the broker-dealer will provide all the terms at which they will extend credit to the customer to allow them to make margin purchases.
It contains crucial information such as which types of situations might lead to a change in interest rates as well as how interest is calculated.
Second, we have the hypothecation agreement.
We covered this extensively above but there are a few things to add.
To clear the way for this process to happen, any customer securities must be kept in street name.
This will be restored in the broker-dealer’s name.
When this happens, the broker-dealer is seen as the named owner (or nominal owner).
The customer still retains the right of ownership over the securities and therefore they are called the beneficial owner.
Thirdly, we have the form that gives customer consent to the loan agreement.
When a customer signs this, permission is given to the broker-dealer to use their margin securities.
That means they can then loan them to other customers who might need them.
They can also, however, be loaned to other broker-dealers.
When this happens, the securities are borrowed for short sales.
Of all these forms, the credit and hypothecation agreement must be signed by the customer should they wish to open a margin account.
Because it is not a regulatory requirement, they don’t have to sign the loan consent form
Sometimes, however, some broker-dealers will deem this form mandatory and ask the customer to complete it.
Those are the three critical forms first up but there is another that a customer won’t have to sign, but is nonetheless critical.
That form is the risk disclosure document.
This should not only be given to customers when they first sign up for a margin account either.
In fact, the risk disclosure document should be sent to any customer with a margin account each year.
This is critical as the document will show the kinds of risks a customer can expect from margin trading.
- If a maintenance call is not met, when it comes to the securities that can be sold, the customer is not allowed to choose what they are
- It’s possible for a customer with a margin account to lose even more money than they initially put into the account
- A broker-dealer is not obligated to give any customers a time extension when it comes to meeting the margin call
- Without providing any advanced notice to their customers, broker-dealers are entitled to raise their margin requirements
Next, we look at what securities are eligible for margin borrowing.
The securities that can be purchased on a margin are all identified under Regulation T.
It also covers those securities that are available as collateral when a customer wants to make a purchase or secure a loan from a broker-dealer.
These securities below cover both of those options:
- Bonds and stocks that are listed on exchanges
- Stocks on Nasdaq
- Federal Reserve Board approved OTC issues
Some securities, while they can’t be used for margin loan collateral, can still be purchased on margin.
- Call options
- Put options
- Non-Federal Reserve Board Non-National Market Securities OTC issues
- Insurance contracts
The opposite scenario is true too where some securities cannot be purchased on margin but instead can be pledged as collateral.
Note, however, that they must first be held in a customer account for a period of 30 days.
- Mutual funds
- New issues (that met requirements that are listed above)
Lastly, these securities are not subject to the Regulation T requirements:
- U.S. Treasury bills
- U.S. Treasury notes
- U.S. Treasury bonds
- Issues from government agencies
- Municipal securities
In the situation where the above securities are either purchased or sold using a margin account, the initial deposit requirement is subject to the determination of the broker-dealer.
This is based on FINRA maintenance requirements but if the member firm so wishes, they can make them even more rigid.
On the Series 6 exam, you might see a question that will ask you to distinguish between the terms margin and marginable.
- Margin relates to the equity needed to purchase a margin account’s securities
- Marginable also deals with a margin account but specifically with the securities in it that can be used as collateral
When making their first purchase in a new margin account, a customer will need to deposit a minimum amount.
But how is that initial deposit requirement calculated?
Well, there are guidelines provided by Regulation T.
That states that whatever their purchase is, at least a deposit of 50% of the market value of that is necessary.
FINRA too, however, has its own take on what the deposit should be.
Their initial requirement is whatever is less between $2,000 or 100% of the purchase price.
So what does the customer choose then?
Well, the requirement is that they either the greater of the requirement as stipulated by Regulation T or the minimum as set out by FINRA.
Here are a few examples:
- Customer purchases 100 shares at $50 per share
The Regulation T requirement in this situation is $2,500.
The FINRA minimum rule is $2,000.
The deposit the customer will need to pay using our rules above is $2,500
- Customer purchases 100 shares at $30 per share
The Regulation T requirement is $1,500.
The FINRA minimum rule is $2,000.
The deposit the customer will need to pay using our rules above is $2,000.
- Customer purchases 100 shares at $15 per share
The Regulation T requirement is $750.
The FINRA minimum rule is $1,500
The deposit the customer will need to pay using our rules above is $1,500.
Let’s look at another way in which we can break this down:
- When the first purchase made on a margin account is more than $4000, the deposit is per Regulation T requirements and therefore 50% or $2,000
- When the first purchase is between $2,000 and $4,000, the deposit is the FINRA minimum and therefore $2,000.
- When the first purchase is less than $2,000 the deposit is per the FINRA minimum and must be 100% of the price paid for the securities
The last thing to look at in this section is how to define maintenance calls.
Margin accounts can accelerate gains and losses, that we know.
The equity value of the stock in a customer account will drop as soon as the value of the stock they hold drops.
If this happens, a maintenance call might be made on the account.
But when does that happen?
Well, if the equity in a customer account falls below a quarter of the market value of that account (25%), a maintenance call will be made.
Also called a margin maintenance call, when this happens, the equity of the account has to be brought back up to above the minimum level of 25%.
To do this, a customer will have to make additional deposits.
That usually has to take place by the end of the trading day on which the maintenance call was made.
Should this not occur, the broker-dealer will act and bring the account equity back to 25% and above.
They do this by using assets in the account and liquidating them.
25% is the minimum maintenance call as outlined by FINRA.
However, broker-dealers are allowed to set their own and many do opt for a higher maintenance call which is termed a house call.
For the Series 6 exam, calculations based on these maintenance calls won’t happen but you will need to understand the overall concept.
There’s no doubt about it, many registered representatives will spend a large period of their time dealing with customers that are wanting help planning for their retirement.
For the Series 6 exam, you will need to know about the various retirement savings vehicles that are available.
Qualified and nonqualified retirement plans
To start, retirement plans are found in two basic types: qualified and nonqualified.
For qualified plans, although there are some exceptions to the rule, pretax contributions are allowed.
For nonqualified plans, it’s always after-tax money that will fund it.
Both, however, allow money to grow without being taxed.
In other words, they are tax-deferred.
Of course, as with many things in the world of securities, there are some exceptions to what we have covered above.
When it comes to contributions to these plans, well they differ too.
For example, while they are not allowed for nonqualified plans, qualified plans have contributions limits but they will vary.
Every now and again, these contribution limits might be adjusted on nonqualified plans.
While there are some exceptions, most retirement plans are taxed as ordinary income and capital gains taxes won’t be applied to any distributions on them.
Here’s a handy breakdown of the various aspects of a qualified vs. nonqualified retirement plan.
- Tax deductible contributions
- IRS approved
- No discrimination
- Deferred tax on accumulation
- Taxed withdrawals
- The plan needs to be a trust
- Non tax deductible contributions
- No need for IRS approval
- Discrimination is possible
- No discrimination
- Deferred tax on accumulation
- Excess over cost base taxed
- It’s not required that plans are a trust but they can be
Over and above what we have just covered, retirement plans can also qualify as self or employer-sponsored.
Should an individual have set up a retirement plan for themselves, that’s known as a self-sponsored retirement plan.
If the employer has established the plan for their employees, that’s an employer-sponsored plan.
Self-sponsored nonqualified plans
You’ve heard of an annuity, right?
Well, that’s the most main type of self-sponsored nonqualified plan that you will come across.
There are a few basic things to know about these types of plans.
Any contributions made to them cannot be deducted from income.
These plans will also grow in a tax-deferred manner and any gains made will be taxable when a withdrawal is made from the plan.
Lastly, regulations do not stipulate how much a customer can invest in these plans and they don’t require that the customer have an earned income.
Self-sponsored qualified plans
There is a range of different types of self-sponsored qualified plans, some of which we are going to look at in a little more detail.
We start with traditional individual retirement plans or IRAs as they are known.
First created in 1974, the IRAs sprung forth from the Employee Retirement Income Security Act (ERISA).
The main aim of this act was to try and get people to plan for their retirement by saving by using IRAs over and above other retirement plans (for example, employer-sponsored ones) that they are already part of.
So how do IRA contributions work then?
Well, whichever is less between 100% of earned income or an indexed maximum (currently $6,000) can be made as an annual contribution to these plans.
Note the term “earned income”.
This is exactly what it sounds like.
In other words, it’s money made from work and includes the following categories:
- Other income generated from working
Earned income is not anything extra made from an investment, for example.
For customers over 50, an additional $1,000 can be contributed annually.
This is known as a catch-up provision.
Customers might want to contribute towards an IRA along with their spouses.
Those contributions are then based on the earned income of the married couple.
Providing the combined income is sufficient here, contributions are allowed for a spouse that surpasses his earned income.
A 6% penalty for excess contributions over the allowable portion will be applied should the contribution limit be infringed.
If done in error, this can be corrected according to IRS rules but this must be done quickly otherwise the penalty will apply.
Up until April 15 of the following year contributions for a tax year can be made.
Contributions to an IRA for the previous year as well as the current year can be made from January 1 to April 15.
Based on income limits and access to corporate plans, traditional IRA contributions are either fully or partially deductible or not deductible at all.
Notwithstanding a customer’s income, contributions are fully tax-deductible when a qualified employer plan does not cover an investor and their spouse.
Should they either be eligible for coverage or are covered, the situation changes.
Should the taxpayer’s adjusted gross income be within the income guidelines that have been established, then only contributions are deductible.
In other words, less can be deducted the more the investor makes.
Contributions are still allowed to be added should the AGI exceed a certain amount.
Just know that once this happens, any contributions made afterwards are not considered to be deductible.
While discussing IRAs we need to talk about distributions.
These will be treated as taxable income for traditional IRAs.
Part of the distribution will be tax-free if after-tax income accounts for a portion of the contributions.
A distribution will be subject to a 10% penalty as well as income tax if they are made before the owner of the IRA has reached the age of 59.5.
If they are made after 59.5 then this penalty will not apply.
The penalty, however, does have some exemptions.
If the distribution is due to one of the following below, there are exceptions to the penalty:
- The owner of the IRA has died
- The owner of the IRA has suffered a disability
- The owner is buying their first home as a principal residence (up to $10,000 may be taken)
- For education expenses for the spouse, child, grandchild, or taxpayer
- For unemployed individuals medical premiums
- Medical expenses that are beyond AGI defined limits
We also need to mention the required minimum distributions (RMDs).
In the year that the individual who the IRA is for turns 72, by the April of the following year, the RMDs must start.
As for distributions, well that must begin in the year the individual who the IRS is for turns 72 as per IRS requirements.
They can, however, choose to put off the distribution of that year until April 1 the next year.
Once the first distribution has been made, any further that will follow will now have a due date of December 31.
Should the first distribution be delayed until the next year, a further one will need to be taken in that year as well.
The due date for that distribution will also be December 31.
In other words, if the first distribution is delayed to the following year, two distributions will take place during it, one on April 1 and the next on December 31.
This is a question that sometimes appears on the Series 6 exam.
Note that there is a penalty that will apply should RMDs start after the customer has turned 72.
Remember, they must start by April 1 of the year following.
These penalties are currently 50% and are charged due to excess accumulation.
Penalties are not a set value but instead are worked out based on IRS life expectancy and the amount of money that needed to be taken.
The full amount will also be subjected to regular income taxes.
If further annual RMDs are missed (for example, they are not withdrawn by December 31 in the second year), the penalty will apply to them as well.
When it comes to the funding of IRAs, there are investments that regulations do not permit.
Here’s a list of investments that are not allowed to fund IRAs:
- Antiques, rare coins, artworks, stamps, or any other collectibles
- Contracts for life insurance
- Municipal bonds (as their tax-free benefit isn’t available within a retirement plan, these are not appropriate although, technically, they are permitted. Even such, justifying the reasons to use them in an IRA is very difficult, so no broker-dealers use them)
The following investment practices cannot be carried out within any type of retirement plan, including IRAs:
- Margin account trading
- Selling stock short
- Uncovered call options sales
Annuities, but not life insurance, are allowed within IRAs, although regulators are concerned about the suitability thereof, especially as a product with tax advantages (the IRA) is being funded by another (an annuity).
So what investment options are perfect for IRAs then?
Well, here are some, but not all of them:
- Stocks and bonds
- Mutual funds
- Government securities
- Gold and silver coins issued by the U.S. government
Let’s move our focus to Roth IRAs.
While a type of IRA, these are different in a few ways:
The first difference is to do with contributions that are combined for a Roth IRA together with a regular IRA.
While investors can contribute to both separately, when it comes to calculating if they have exceeded the annual maximum for the year, these contributions are counted together.
From a tax perspective, any contributions towards a Roth IRA won’t be tax-deductible.
Are there individuals who cannot contribute to Roth IRAs?
The answer to that is yes and it happens when they earn above a certain limit.
This is just for informational purposes and this limit won’t appear in a question on the Series 6 exam.
Our second difference is related to growth.
With a Roth IRA, any growth that happens within the account will always be tax-deferred.
The third difference is distributions.
These will be tax-free if certain conditions are met.
These conditions are that the account holder must be 59.5 and older and they must have had the Roth IRA for a period of five years or more.
Should these conditions not be met, distributions will have a 10% penalty added as well as being taxed on earnings.
While Roth IRAs do not have RMDs like traditional ones, contributions are allowed to be withdrawn at any point without tax implications.
We also need to cover rollovers and transfers.
A withdrawal of funds from an IRA that gets returned at a later point is known as a rollover.
There is a time frame that the funds must be returned, however, and that’s a period of 60 days.
Note rollovers can only be carried out once per year (12 months, not a calendar year).
Something to note too is that these rollovers are not per account, but per person.
As for a transfer, this sees the assets of one qualified account moving to another.
Any number of transfers are allowed under regulations and the investor never will get possession of the funds at any point.
Effectively, they just move from one account to another.
Can assets be transferred between a traditional IRA and a Roth IRA?
Yes, they can and when this is carried out, there will be no penalty applied.
When an amount is transferred between a Roth and a traditional IRA, it will be seen as taxable income.
Employer-sponsored nonqualified plans
When it comes to these plans, there are two types that you will need to know about.
These are Section 457 plans and deferred compensation plans.
We start with deferred compensation plans.
With these plans, an agreement is in place between an employee and the company they work for.
This agreement sees the employee opt for a retirement payout by deferring the receipt of current income and by the time they reach retirement age, it’s presumed that they will be in a lower tax bracket.
These plans are seen as a little risky based on the type of business.
That’s because if the business does fail, the covered employees of the company won’t receive the plan benefits.
There is a chance that they could receive some of the benefits because if this situation occurs, the employers move to become general creditors.
What about if an employee leaves the firm before they retire?
Well, in that situation, they will generally have to give up their benefits.
As for employer contributions to the plan, because they retain control of the assets, they are taxed appropriately.
Contributions are not considered an expense to the employer.
On an employee’s retirement, the benefit is payable.
This will be taxed as ordinary income when paid out.
When the benefit is paid out to the employee, their employer will be able to receive a tax deduction.
Contributions to these types of plans are usually held in an annuity or other similar tax-deferred accounts.
For the most part, these plans are often used for employees that are nearing retirement and are either key and/or well compensated by the employer.
The second type of employer-sponsored nonqualified plans to look at is Section 457 plans.
For these plans, the employer is state and local governments.
They are available to both their regular employees as well as those on contract.
Operating as a deferred compensation plan, the earnings within them will continue to grow.
They are also tax-deferred.
At the time that they are distributed, withdrawals will be taxed.
100% of their compensation can be deferred by employees but only to an indexed contribution limit.
Employer-sponsored qualified plans
For the Series 6 exam, we only need to focus on those qualified plans that are corporation sponsored although there are different types.
Let’s start with defined benefit plans.
With these retirement plans, the employee that retires will receive a specified benefit.
A formula is used to determine this and it takes into account the following parameters:
- The retirement age of the employee
- How many years of service they have with the company
- The level of compensation they have reached
The trust agreement of the plan will help determine the contribution amounts and various actuarial calculations will help these amounts.
These calculations will factor in the following (amongst others):
- Investment returns
- Interest rates in the future
When older employees are the ones that a firm wishes to favor when deciding on a benefit plan, this is often what they turn to.
That’s because these employees have a shorter time to their retirement and this plan will allow for greater contributions to be made.
Next, let’s look at defined contribution plans.
For companies, these types of plans are often far simpler to manage.
The trust agreement of the plan will determine what the contribution amounts are.
As for the funds contributed, well they are held in separate accounts for each of the employees.
When it comes to benefit payouts at retirement, that’s not readily available.
When younger employees are the ones that a firm wishes to favor when deciding on a benefit plan, this is often the best option.
That’s because more time is involved and the money in each individual plan has far more time to grow.
When we speak of defined contribution plans, there are numerous types:
- Money-purchase plans: These are the most basic of the qualified defined contribution plans. An employer can offer this plan to their employees as long as they meet the funding requirements. Their contributions take into account the compensation of each employee and are a specified percentage there off up to an indexed maximum.
- Profit-sharing plans: One of the most popular of these plans, contributions are not fixed and can actually be either skipped or reduced if the business hasn’t made a profit during that financial year.
- 401(k) plans: When you think of a qualified defined contribution plan, this is the one most people would name and it certainly is the most popular type. Here the retirement account is filled with contributions made by the employee but they can select the amounts that they want to contribute. These contributions will accumulate in a tax-deferred manner but are not part of the gross income of an employee. An employer contributes too, and those contributions must match that of the employee. Hardship withdrawals are allowed from these types of plans.
- Roth 401(k) plans: One of the newer types of defined contribution plans, this allows tax-free withdrawals and contributions are after-tax. For those individuals over 59.5 years of age. Roth 401 (k) plans differ from a Roth IRA in the fact that who may opt for a plan like this isn’t curtailed by income limitations. Employers can make contributions, but these will go into a regular 401 (k) account. The employee, however, has two options as to where they can place their money. If they want to, they can contribute to both but once money has been deposited in one account, it cannot be transferred to the next. Unless they are still working, withdrawals have to be made out of the account by the age of 72.
- Simplified employee pension plan: Also known as a SEP: When small companies are looking for a pension plan for their employees, they often turn to SEP. Here, until the time the employee retires, contributions made will grow tax deferred in individual accounts. Usually, an employee will open an IRA account in which an employer, on their behalf and from their remuneration package, will make contributions. This type of arrangement is called a SEP-IRA. Non-SEP contributions, which are from the employer, are then made into the individual accounts as well. When compared to other IRAs, contributions are higher for SEPs. In fact, up to 25% of the salary of an employee, up to an indexed maximum, can be put into a SEP-IRA. Not all employees can participate, however. They have to have worked for the employer for at least three years of their last five-year work cycle, be 21 or older and in that current year, have a minimum level of compensation paid to them.
Required beginning date for Corporate Plans
So far, we’ve looked at when IRA minimum distributions must begin in terms of age but what’s the deal in that regard when it comes to qualified corporate plans?
Well, these have a special term that covers this and it’s known as the “required beginning date”.
Qualified retirement plan distributions must start to a participant by April 1 of the following years (whichever is later):
- When the participant reaches the age of 72, the first year thereafter
- When the participant retires from the employer who is maintaining the plan, the first year thereafter
So there are no minimum distributions required until retirement and contributions can still be made for a participant of the plan that is still working for an employer and is over 72.
Stock purchase plans
The option to purchase stock is something that many publicly traded companies provide the option of to their employees.
While there are numerous ways that this can be done.
We are going to look at the method that’s the most simple, however.
That’s the employee stock purchase program (ESPP).
In terms of giving employees a way to purchase stock in the company that they work for, it’s the most straightforward method of them all.
ESPPs operate in a simple and effective manner in which the employee themselves won’t have to carry out the transaction.
Instead, they give their employer permission to take money off their paycheck.
This is done after tax and whenever the employee is paid.
That money is then placed in an escrow account, accruing interest.
Then every so often (and it’s different for each company), the money will be used to buy stock on the employee’s behalf.
For example, this could be every three or six months that the stock purchases are made.
These are more liquid and certain don’t have as many restrictions as other plans where employees can purchase stock options in a company, like formal stock option arrangements, for example.
They are similar in a way, however, and that’s because they encourage employee ownership by buying stock.
Let’s look at a few more details when it comes to ESPPs:
- Between 1% and 10% are the options an employee can choose as the deduction from their salary each pay date that will then be placed in the escrow account as detailed above. This is taken after tax but always worked out on a pretax salary. ESPPs contributions don’t have tax deductions, unlike 401(k) plans.
- The purchase period is the time the funds are collected. For most ESPPs, this is six months. When this ends, the contributions are used to buy company stock at a discount for each individual employee. To work out the price of the stock, the cost from the beginning and end of the purchase period is noted. The lower price of the two as well as a discount on top of that will determine the price that employees pay for their stock.
- If they wish, employees can choose to sell the stock right away. If they don’t they will receive favorable tax treatment.
There’s another situation that can play itself out when it comes to employees and company stock.
Stock options may be offered to employees by the employer that allows them the right to buy company stock at a specified price and for a specified time period.
Usually, there is a specific number of shares that each employee is allowed to buy in this scenario.
1974 Employee Retirement Income Security Act (ERISA)
ERISA provides various guidelines for some union retirement plans as well as those in the private sector and was introduced as a way to prevent their misuse and abuse.
Note, however, that it doesn’t cover any public plans, for example, those that are put in place as a way for government workers to save towards their retirement.
ERISA has numerous provisions, which start with participation.
The first major thing that ERISA controls is which employees are eligible for the retirement plans.
There are two basic requirements when it comes to this.
First, if an employee wants to sign up for the relevant retirement plan, they must be over the age of 21.
Second, they must have worked for their employer for at least one year.
They even equate that into an hourly value for those employees that work hourly shifts and it comes to 1,000 hours and above.
The second provision is funding.
Other company assets and those funds that they contribute towards the relevant retirement plan cannot be combined.
The best interests of all employees that form part of the retirement plan must always be kept in mind by the trustees that administer the plan and invest assets to help it grow.
At all times, contributions limits as specified by the IRS must be adhered to.
The third provision is vesting.
Vesting rules help determine when the employee can access the money that their employer has contributed to their retirement plan.
The employer’s vesting schedule is limited by ERISA.
At the end of it, the employer is said to be fully vested.
As for an employee, well, in their plan contributions, they are always said to be fully vested.
The fourth provision is communication.
Employees are entitled to receive annual statements for their plans as well as any changes to the plan benefits should that happen.
The overall plan document also must be available in a written format.
The fifth provision is non-discrimination.
When it comes to determining employee and employer contributions to a retirement plan, there is a uniform applied formula that must be used for all.
A sixth provision is beneficiaries.
All employees that have a retirement plan will have to nominate beneficiaries.
Should they die before retirement, it’s these beneficiaries that will receive the payout from their retirement plan.
CUSTOMER TRANSFERS, AND REGISTRATION CHANGES
Who owns an account will be shown in that account’s registration.
For the most part, if an account changes ownership, because they are designed to do so, it will mean that it should be closed and a new account opened to reflect the ownership change.
That’s not all we will cover in this section.
From time to time, an individual might want to move their account from one broker-dealer to another.
That will require a transfer and it’s something that we will cover as well.
Changing the registration on an account
Depending on the type of account in question, registrations are handled differently.
Let’s first look at individual accounts.
To start, let’s look at the process if an individual account owner changes their name, for example, they got married and took on their spouse’s surname.
In this situation, a letter of authorization (LOA) from the holder of the account will be requested by the broker-dealer.
They will also have to supply legal evidence that their name has changed, so in the example we looked at above, this could be a marriage license that reflects their name change.
Individual accounts can also become joint accounts but the tax ID number of the individual must always be the same as a broker-dealer.
Should the situation require a change in the tax ID number, then a new owner will need a new account opened.
The assets can only be journaled (or moved from one account to another in the broker-dealer) to the new account if an LOA is obtained from either the representative or the current account owner.
What about joint accounts?
If all the account holders in a joint account give the go-ahead, a new tenant can be added to the account.
That tenant will need to complete a new account form to be added to the joint account.
As for the removal of a tenant, well that will mean a new account has to be opened, and then a journal transfer is the only option.
They cannot just be removed from the joint account.
Now let’s look at business accounts.
Authorized persons for a partnership or corporation can be changed if need be.
To do this, a new resolution will need to be passed to give the new individual the required authorization.
Should this situation occur, a new account will not need to be opened because the individual is not the owner of the account, the entity is.
We need to look at trust, custodial, and guardianship accounts when it comes to changing registration.
If a trustee, custodian, or guardian changes on one of these account types, much like a business account, their ownership doesn’t change at all.
If this situation plays out, a new account is not needed but the LOAs need to be carried out.
Transferring accounts from one broker-dealer to another
Usually called a TOA or account transfer, the process of transferring an account from one owner to another is usually automated.
It’s carried out through the Automated Customer Transfer Service (ACATS).
The process is therefore standardized.
To start, a Transfer Initiation Form (TIF) will need to be completed and signed by the customer that holds the account.
Note that the new firm that will be receiving the customer’s account is tasked with sending it to ACATS.
From there, ACATS will pass the form onto the customer’s current broker-dealer.
They are tasked with validating the customer’s securities that are currently in the account as found on the TIF.
They can also object to the instructions in the transfers.
Whatever happens, however, they only have one business day to do so.
Once the account has been validated, within three business days, the transfer of the account must take place from the old (carrying) firm to the new (receiving) firm.
Only if there is a claim against the customer’s account can a broker-dealer hinder a transfer.