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In this module we cover everything to do with clients, making investment recommendations and drawing up investment strategies.

A. Types of clients

Clients can include individuals, people with a joint account, and more

Catergories of account ownership

Let’s look at the various types of clients you will come across. 

Individual accounts

These accounts have one beneficial owner and are for:

  • Natural persons
  • Trusts
  • Estates (of a deceased person)
  • Sole proprietorships

With all of these, a written statement of objectives must be drawn up by the adviser.

These objectives as well as the investment profile of the client should be reviewed periodically as they may change.

Note, only the account holder can control investments of the account or make requests for distributions from it.

Joint accounts

This is owned by two or more people with suitability information required from all parties. 

Note, that each has control when it comes to the joint account.

There are three types of joint ownership accounts:

  • Tenants in common (TIC)
  • Joint tenants with rights of survivorship (JTWROS)
  • Tenants by entirety (TBE)

Let’s look at each a little closer, starting with tenants in common.

Under a TIC, a deceased tenant’s fractional interest in the account is kept by the estate and not passed on to the remaining tenants.

A TIC account does, however, allow for unequally divided ownership.

If a tenant does die, their cash and securities will follow instructions in their will in terms of distribution.

Next is joint tenants with right of survivorship.

With a JTWROS account, should a tenant die, their account interests are transferred to the other remaining tenants.

Note that there is an equal interest for all tenants participating in this type of account, no matter their contributions.

Then we have tenancy by entirety.

As with TIC and JTWROS accounts, tenants in these TBE accounts have an undivided interest.

They differ because a TBE is the only joint account that is only allowed for married persons. 

Should a tenant want to give away or sell their portion of the account, the other tenant must agree. 

Should a spouse die, the other will receive their portion of the account. 

Legal requirements for opening accounts

Let’s look at an individual account.

To start, a new account agreement must be completed.

This is crucial as it acts as a contract and explains the rights and obligations of both the client and the adviser. 

Customer identification information (CIP) is important too, as well as their legal capacity and employment information.

With joint accounts, all those involved must provide the above details with one chosen as the primary contact and will receive all necessary communications.

While NASAA doesn’t have guidelines when it comes to opening options accounts for clients, FINRA does.

These accounts have to be approved by a supervisory person before they can be opened and this is because they involve more risk for investors.

Part of opening an account like this sees the client sent an Options Disclosure Document (ODD) highlighting those risks and how options work. 

A new investor is not going to be able to open an options account, it’s only for experienced ones that have shown they understand what it entails. 

If an account is given approval, this indicates:

  • When the client received the ODD
  • On which transactions the account has been given the go-ahead for
  • The agent assigned to the account
  • Who approved the account (the name of the supervisor)
  • When it was approved (date)
  • Date when account information was verified. 

Customers will have to provide a written agreement within 15 days of the account having been approved that they understand the FINRA rules binding them when trading options.

Business accounts 

Next, we move on to business accounts

Sole proprietorships

While this is a business account, it’s the simplest way to set up one and it’s handled just like an individual account. 

This means when it comes to suitability, the rules are the same.

With a sole proprietorship, the individual involved takes on all the income gained or losses incurred and their assets can be claimed to pay any business debt. 

General partnership

There are two or more people involved in an unincorporated association in a general partnership. 

Here, the partners not only manage the business but also can be held liable for debt. 

For tax purposes, any profits or losses in a partnership will flow through to investors and double taxation won’t occur. 

Limited liability company (LLC)

This structure integrates a partnership’s tax advantages, including flow-through with the limited liability associated with incorporation. 

Those who own an LLC are never shareholders, but members, and any debt incurred will not see them personally liable. 

Members of an LLC must be viewed in isolation when it comes to suitability. 

S Corporation

The benefit of an S corporation is that it provides investors with limited liability although when it comes to tax, it’s treated the same as a partnership.

Depending on their ownership proportion, profits and losses are passed through to investors which can never amount to more than 100.

C Corporation

Here, the owners and the company are viewed as independent entities.

In the case where a large capital sum is needed, this type of structure is usually chosen. 

Any officers of the corporation cannot be held personally liable for debt incurred and corporate creditors cannot go after shareholders either. 

Shareholders won’t have any corporate income tax passed to them but instead, only the corporation is covered. 

Fiduciary accounts 

With these accounts, the adviser is given the power to make trades on behalf of an investor. 

They also manage the account, make distribution decisions, and more but always in the best interest of the owner. 

Here’s some examples of fiduciaries include:

  • Trustees
  • Executors
  • Administrators
  • Guardians
  • Custodians
  • Receivers

If someone is authorized and legally appointed to act on behalf of another party, they are a fiduciary. 

Let’s look at some of the more important types of fiduciary accounts. 

Trust accounts

For those who wish to transfer property – both personal and charitable – a trust account provides the flexibility to do so and is considered a legal entity.

For the exam, you will need to know the responsibilities of a trustee, how trust taxation works, and the role of an adviser when working with trusts.

Let’s start by looking at the parties involved in trusts

Valid trusts involve three parties as specified in the trust agreement document.

These are:

  • Settlor
  • Trustee
  • Beneficiary

In some situations, these three roles can be fulfilled by one person.

While the settlor and trustee will have to be competent parties for a valid trust, in many cases, the beneficiary can be a minor or a legally incompetent adult. 

The property for the trust is provided by the settlor. 

The trustee, acting as a fiduciary, is either a party or individual that holds the property’s legal title.

They do this for the welfare of another and act in a similar way as an executor of an estate.

Finally, the beneficiary is the individual for whom the property is held in trust and who will receive it at some point in the future. 

Next, we must compare simple trusts vs complex trusts

It’s during the year that they are received that any income earned on assets in a simple trust must be distributed.

The trust is considered a complex trust should this not happen.

These trust types can build up income, while deductions for distribution of either the principal or net income are allowed.

Unless they are reinvested, any capital games in a complex trust are part of the distributable net income. 

The most important difference between the two is the distribution of income as highlighted above.

Then we have living vs testamentary trusts

It’s during the lifetime of the maker that a living trust is formed.

The control over a revocable living trust is in the hands of the individual who started it.  

Assets can be added or removed and other changes made whenever necessary.

With a testamentary trust, it’s until death that the settlor will be in control of trust assets.

The will of the individual will then state that the testator’s property is placed in trust for beneficiaries upon their death. 

Charities and foundations

We start this section by looking at philanthropic funds

These funds allow certain flexibility and tax advantages for those that donate to them and are usually started by wealthy individuals.

Banks and mutual fund sponsors provide individuals with the chance to donate a large sum of money to these.

For that, they get a current tax deduction as well as invest assets to earn over a period.

The donor then will look to favored charity and advise distributions to them. 

The next to look at is impact investments

What are impact investments?

Well, it’s when a positive social or environmental impact that is measurable is made with capital that has intentionally been allocated. 

It’s about finding a charity or company that aligns with the goals of an entity who then commits funds towards them to help them reach those goals. 

This is a segment of SRI or socially responsible investing. 

Then we have management obligations

Here, a board of directors manages a foundation and they are tasked with choosing and presiding over the investment manager’s activities. 

This involves an investment policy statement (IPS) prepared by them in which the objectives and goals are described.

The performance of the investment manager is also judged by what is outlined in the IPS. 

B. Client profiles

Each client is unique and it’s up to the adviser to find out everything they need to know about them to help them towards their investment goals. 

An account cannot be opened without finding the necessary suitability information about a client. 

This is how an adviser would go about this. 

The financial status of a client

A client’s financial status is part of the information an adviser will need to secure. 

In this section, we look specifically at how you can go about finding this all out. 

Usually, this would include having a client complete a very detailed questionnaire.

That’s just the start and an interview would also be necessary and it’s the best way to secure information such as their investment attitude and tolerance for risk. 

The financial profile of a client

The assessment of a client carried out in a financial profile will contain vital information such as:

  • Their tax status
  • Their expenditure currently
  • Their debt obligations
  • What sources of income they have
  • A balance sheet noting all their assets

This information allows the adviser to reflect on all the client’s assets and liabilities in a family balance sheet.

This will not include income like salaries, however, something to note for the exam. 

It also will give an overview of their net worth as well as their liquidity and cash flow.

This balance sheet provides an indication if the investor is able to make lump sum investments, or if they can only make them periodically. 

Non financial considerations

We next move on to critical nonfinancial aspects regarding a client that needs to be considered.

This includes non-monetary information such as age, marital status, their experience when it comes to investments, dependents, stability of employment, educational and healthcare needs, and more.

You can easily see how important this information can be. 

Investor tolerance for risk

Working out risk tolerance for individual investors is a must.

This takes in risk or safety and their attitude towards it which should always be the factors that mold their investment profile, not their financial status. 

When deciding on the types of investments for a client, several variables must be considered:

  • The client’s investment objectives
  • How much disposable money they have to invest 
  • The client’s risk aversion

As part of working out a client’s risk aversion, the following information will help:

  • What’s the maximum loss that the investor can bear?
  • How liquid should their investments be?
  • What tax considerations do they have?
  • Are they looking at short or long-term investments?
  • What investment experience do they have?
  • Do they have any current investments?
  • What are their targets for returns?
  • What is the client’s investment temperament like?
  • How are they affected by fluctuating markets?

When determining a client’s risk tolerance, we usually put them in one of three categories: conservative, moderate, or aggressive. 

  • Conservative: Prefer low risk to principal loss with guaranteed income
  • Aggressive: Willing to accept losses of up to 50% and ride out market volatility for the chance of substantial returns.
  • Moderate investors: Have an investment approach between conservative and aggressive.

The potential investments you can suggest to a client will be narrowed down based on their tolerance for risk and overall market volatility. 

Investment objectives and constraints

Let’s look a little more into the objectives a client might have when it comes to investments as well as various constraints that could affect them.

We’ve covered what you need to do to get some information about a new client and with this, and their help, the next step is drawing up financial goals.

Usually, these goals are one of the following:

  • Capital preservation
  • Generate current income
  • Capital growth
  • Speculation

Investment constraints will stand in the way of these goals, so they need to be carefully considered as well. 

Constraints can include:

  • Time horizon (or when the goals need to be met by)
  • Liquidity
  • Taxes
  • Laws and regulations
  • Unique preferences or circumstances

Capital preservation

Some investors do not want to see their investment decline, so capital preservation is critical for them. 

The safety they are looking for can be provided by investments such as money market funds, savings accounts, and bank-insured CDs. 

Of course, going the safety route affects income, so returns are low. 

Also, there is still risk in the form of inflation because these are fixed-income investments. 

Generate current income

When looking to focus on ensuring a steady stream of current income, mutual funds and individual securities provide the best platform.

These include:

  • Agency bonds
  • Government bonds
  • Government notes
  • Preferred stock
  • Common stock of utility companies

With the need to provide income comes risk and how much an investor is prepared to take on. 

As always, more risk equals more return. 

Capital growth

If you want to preserve and even increase an invested money’s buying power, then common stock investments are an excellent option. 

For returns over time, although it’s a little more volatile in the short-term, equity markets are the way to go.

When we talk about growth, there are many investments to choose from. 

Again, it depends on the investor themselves.

For those with a high risk tolerance and a long investment time horizon, aggressive growth stocks are a good choice.

On the other side of the coin, we have less risky large capitalization stock funds. 

These invest in well-established, respected corporations and are perfect for older investors with around three to five years until they would want to liquidate their investments.


Using some of their investments, a customer might choose the route of speculation.

While this can earn massive returns, speculation is risky.

Here are some investments that are perfect for speculation:

  • Stocks that are highly volatile
  • Junk (high yield) bonds
  • Options on stock
  • Options on stock indexes
  • Commodity futures

Now that we’ve covered the four main investment objectives, let’s look at other reasons why people invest.

This includes:

  • To pay college tuition
  • To ensure money for their retirement
  • To provide death benefits for their family when they pass away
  • To ensure there is money available if they suffer a disability

These are adequately covered in Series 65 coursework, so we won’t get into too much detail with them. 

College tuition

Here, the perfect suggestion is zero-coupon bonds with a maturity date linked to when tuition fees are due, or when their dependents will start college. 

There are various investment programs with distinct tax advantages for those wanting to invest in this manner, like Section 529 plans. 


Considering a client’s company pension, social security, savings, and insurance are crucial when working out their specific retirement needs.

A critical element to consider here is time horizon and obviously, the earlier they start the better. 

Earlier starts also mean that more risk can be taken with that dropping as they approach retirement age. 

To ensure accumulated money lasts for the time period after they have retired, look to investments that lower longevity risk.

These include annuities (fixed, index and variable) as a payout for life is guaranteed.

Death benefits

While it’s never pleasant to think of, a family losing their primary breadwinner is devastating. 

That’s why many clients want some form of death benefit as part of their investments and this usually comes in the form of life insurance. 

Capital needs analysis is the perfect tool to help determine just how much they do need and life insurance should be able to:

  • Payoff outstanding debt
  • Payoff outstanding mortgages
  • Provide income for the family left behind for a reasonable time
  • Provide tuition fees for dependants


Three forms of replacement income exist for a client that becomes disabled.

These are social security, workers’ compensation (if they were injured while working), and social security. 

Time horizon

The last thing to mention in this section is time horizon which we’ve covered briefly.

Let’s just reaffirm what it is.

Let’s take an investor that is 30 years old.

If they are investing for the next 20 to 30 years, then short-term volatility in their investments first up is acceptable.

That’s not acceptable to someone who is retiring in five years.

Instead, their investments should be safe and liquid. 

When planning for their retirement or for their children’s education, time horizon is one of the most critical constraints to consider. 

C. Capital market theory

The core of modern portfolio theory holds that for the most part, investors will behave in a rational manner. 

When we talk of capital market theory, we look specifically at models like Capital Asset Pricing Model (CAPM). 

Capital Asset Pricing Model (CAPM)

As a market theory, CAPM allows the expected rate of return to be determined by the investor. 

This looks at how much risk needs to be taken by the investor to reach their desired return. 

In other words, the return is risk-adjusted. 

This is achieved by looking at the asset’s non-diversifiable or systematic risk. 

CAPM holds that two distinct risks are associated with all investments: systematic risk and unsystematic risk.

In the case of systematic risk, diversification cannot make it go away, while that will help with unsystematic risk. 

Modern portfolio theory (MPT)

This looks specifically at ways in which portfolio risk can be quantified and controlled. 

Unlike other modern analyses, this doesn’t analyze specific securities but instead looks at the total portfolio and the risk and reward thereof.

MPT determines that the risk of certain investments can be nullified through diversification.

This is achieved by construction portfolios with investments with uncorrelated returns. 

At the same time, MPT sees the portfolio raising the returns expected. 

For MPT to work, risk can only be reduced through diversification if the assets have prices that move either inversely or at different periods. 

This leads to decreased risk due to decreased correlation. 

Efficient market hypothesis (EMH)

This says that when new prices are available, security prices adjust quickly to it.

Their price also reflects the information that is made available to the market. 

This means that markets are usually fairly priced.

Based on information available, EMH has three versions.

Firstly, there is weak-form market efficiency.  

This says that all the historical data pertaining to the market as well as price trends is incorporated in the price of current stock. 

Because of this, predicting future price changes has no value. 

Second, we have semi-strong-form market theory

This says that not only historical price data but also that of analyzing financial statements, the economic outlook at present or industry is reflected in current stock prices. 

Third, is strong-form market theory

Here, it’s both private and public sources of information that are reflected in the prices of securities. 

This theory also includes information gleaned from past securities markets and in a nutshell, there is no one group of investors that has monopolistic access to this information, it’s there for all to see.

In terms of fundamental and technical analysis when applied to these three versions of EMH, consider the following:

  • Weak-form: Technical analysis doesn’t work. Insider information and fundamental analysis will work
  • Semi-strong form: Technical and fundamental analysis won’t work. Insider information will work
  • Strong-form: Technical and fundamental analysis won’t work and neither will insider information. Random walk will work. 

D. Strategies, Styles, and Techniques of Portfolio Management

Let’s start with the various strategies that can be employed.

Strategic asset allocation

Here, consideration is given to an investment portfolio with long-term goals.

The main focus is the proportion of the various investment types in that portfolio. 

With strategic asset allocation, we look at a long-term investment portfolio specifically with regards to the proportion of the various types of investments found in it.

For a portfolio manager that takes a passive approach, the belief is that when it comes to outperforming market averages on a consistent basis, no management style can.

Therefore, the portfolio they put together will look at a market index and mirror it. 

Or they will simply suggest certain ETFs or index funds their client should invest in.

The idea of a passive approach is to look to secure long-term returns with minimal turnover.

Tactical asset allocation

With this form of asset allocation, the portfolio manager takes a more active role.

This means that they will make short-term adjustments to a portfolio that mix up the asset classes based on investor sentiment and the market conditions currently. 

They will use an approach that looks specifically at selecting the right stock and will buy and sell individual securities to do so. 

This active selection along with market timing is critical as a way to outperform market indexes. 

Timing involves buying and selling securities at the right moment as well as trying to predict the movement of stock prices in the future. 

Overall, however, this is not about timing a specific security but the market overall. 

Other styles of portfolio management

Let’s look at some other styles of portfolio management that can be used.


When an investment manager uses this technique, they are going against the grain and in the opposite direction.

Yes, a contrarian will also invest opposite to current market beliefs or what other managers are doing. 

Capital appreciation vs income

This isn’t the same as growth vs value, despite the similarities.

Let’s start with capital appreciation.

This can take many guises depending on the needs of the investor.

It could be moderate, and it could even be aggressive. 

Capital appreciation is obviously linked to growth stocks, but other securities can provide it too.

These include special situation stocks, options, futures IPOs as well as day trading. 

Income, as we’ve seen, is all about ensuring that’s what a portfolio generates. 

Often, portfolio managers migrate to high-yield bonds and foreign securities to generate income but those can be risky.

Debt securities are another investment option that generating income will rely upon. 

Monte Carlo simulations

MCS is a form of scholastic modeling where distributions are computer generated and provides both risk management and analytics in the many probabilities it generates. 

This gives an insight into a range of potential outcomes where variables can be tweaked as necessary, including life expectancy for example.

It can then provide both a worse and best case scenario. 

Techniques associated with portfolio management

When it comes to portfolio management, various techniques can be applied. 

Let’s focus on a few that you should remember.

Dollar cost averaging

An investor’s average cost per share can be lowered through dollar cost averaging.

This is used with stocks and mutual funds and sees individuals making regular investments in them consistently. 

This reduces timing risk because the investor is consistently buying shares, more when costs are low but less when costs rise, hence the “averaging out” effect. 

This is because the average cost per share will be less than the average price per share when markets are fluctuating. 

Equity options hedging

A market position can be hedged using options as a way to limit risk, particularly for those investors who own the stock (or a long a position). 

Long stock and long puts

When investors own stock, they could be worried that they will lose money when the price drops.

Buying a put can protect against this. 

If the price does drop, the investor can sell the stock by exercising the put before its expiration date. 

The decline in the price of the stock is then offset by this action and this is commonly called portfolio insurance. 

Covered call writing (Long stock and short calls)

When we speak of a covered call, it’s sold (written) on an investor’s stock that they already own. 

This can achieve two things.

Firstly, it will lower the risk on the long position that they hold.

Secondly, when the call is sold, they will receive income in the form of premiums.

The premium is kept by the call writer should the call not be exercised. 

Delivery of stock by the covered call writer will need to take place when the call is exercised. 

So in exchange for some protection against a loss, a covered call writer will reduce any potential gain they can make. 

Let’s talk a little more about partial protection.

When they write a covered call and then get the premium from it, the premium amount will reduce the stock cost. 

A loss will be incurred if the price of the stock drops below the purchase price minus the received premium. 

The stock will in most cases be called if its price rises significantly. 

Short stock and long calls

An investor is selling borrowed stock when they are said to be selling stock short and do this because they think the price will drop. 

They then will need to repay the stock loan and hope it’s at a lower price by buying stock to do so. 

To protect against stock rises, calls can be bought by the short seller. 

E. Tax considerations

Investments are taxed in different ways, depending on what they are. 

Tax implications can play a massive role in the types of investments that an investor wants to pursue.

Let’s look a little more into this.

When it comes to taxes, there are different filing statuses:

  • Single
  • Married (joint filing)
  • Married (separate filing)
  • Head of household
  • Qualifying widow or widower with dependant

There are other factors to consider:

  • Age
  • State of residence 
  • Citizenship

Capital gains and losses and the tax treatment thereof

There is always a sale of an asset when it comes to capital gains income which can not only be a profit, but a loss too.

Capital gains

When sold at a price than what was initially paid for them, the sale of an asset results in a capital gain. 

Capital losses

The opposite of a capital gain, this happens when an asset is sold for less than what was initially paid for it. 

With both of these, cost basis plays an important role.

When we define what cost basis is, it’s the investment’s total cost and it’s critical in determining if capital gain or loss was made. 

The cost basis will need to be adjusted for stock dividends and stock splits as required by the IRS.

Net capital gains and losses

By adding their capital gains and losses for the short-term (held for 12 or less months), taxpayers can work out their tax liability. 

After that, the addition of any long-term (a period of more than a year) capital gains or losses is made. 

To determine the net capital gain or loss per year, the taxpayer offsets the total.

A net long-term capital gain will result in taxation at capital gains rates, which is usually 15%.

Capital losses are tax-deductible against any income earned but only up to a total of $3,000 per annum. 

Those not taken off can be carried forward for an indefinite period to offset future capital gains. 

Alternative minimum tax (AMT)

Implemented by Congress, AMT sees to it that those that earn a high income are obligated to pay relevant federal income taxes.

To arrive at the alternative minimum taxable income (AMTI), the overall taxable income must have certain items added back into it so that favorable tax treatment can be received. 

These items include:

  • Property accelerated depreciation (must have been placed in service after 1986)
  • Certain limited partnership program costs
  • Interest and local tax on non-incoming generating investments
  • Interest that’s tax-exempt linked to private purpose municipal bonds (issued after August 7, 1986)
  • Some incentive stock options (ISO). The stock price of the option must be less than the fair market value of the employer’s stock. 

So how would you determine if an investor owns AMT?

Well, you need to compute both the AMT value and their regular taxation amount.

Whichever is the higher of the two is what will need to be paid to the IRS.

Income and loss sources

What’s considered as income when we talk about tax considerations?

Well, there’s the regulars such as salary, bonuses, or anything that’s derived from taking part in a business, or trade. 

But there are others too.


We all know what an alimony payment is, right?

It can either be paid to the ex-spouse or, on behalf of them to a third party. 

Note, however, that generally, for the spouse making the payment, these are considered tax-deductible.

The spouse that receives an alimony payment, however, will have to treat it as a form of income for tax purposes.

Child support

Don’t confuse child support with alimony. 

We are talking about a legal obligation to support a child financially here. 

Usually, the parent paying child support won’t have that child living with them, hence the reason why they pay it. 

This isn’t deductible, however, nor must it be reported as a form of income by the recipient.

Passive income and losses

Property rental, limited partnerships, and other enterprises in which an individual doesn’t take an active role are considered to be active income. 

A general partner in a limited partnership will have to report this as an earned income while it’s passive for the limited partner. 

Net taxable income, which will be taxed at regular interest rates is determined by taking passive income and netting it against passive losses.

Any passive income can be offset by passive losses.

Portfolio income

An investor’s portfolio is designed to earn income. 

This can come in the form of net capital gains through selling securities, interest,  or dividends. 

The source doesn’t matter, tax will have to be paid in the year that it was earned. 

We’ve already spoken about capital gains and losses, so let’s look at dividend income

A tax rate of up to 15% can be applied to qualifying dividends. 

And interest income?

Should a debt security provide interest payments to an investor, this is taxed at normal income rates,

U.S Treasury securities other than GNMA or FNMAs will be taxed at federal but not state level. 

Bond fund distributions are fully taxed as ordinary income and aren’t seen as qualified dividends.

For foreign issuer’s income, withholding tax comes into play. This is charged by the issuer’s country of domicile and is usually about 15%.

Tax law in the U.S. currently states that when it comes to withheld tax, this can be reclaimed against any taxes owed to the IRS. 

This is not considered an AMT preference item. 

We also have to mention reinvested distribution taxation

There is a compounding effect created by reinvesting any distributions received by an investor.

Each distribution must be disclosed by the issuer, specifically whether it comes from realized capital gains or from income. 

Shareholders will receive a Form 1099 at the end of each year with distribution related tax information over that period.

All dividends must be reported.

This allows them to be taxed as either a qualifying dividend or as ordinary income. 

Mutual fund distributions will be taxed as capital gains and similar to qualified dividends, they are taxed at a reduced rate.

Last in this section, let’s look at how the cost basis is affected by reinvestments.

When the investor sells the asset, the cost basis will increase and they won’t have to pay tax again.

This is because when the income was reinvested, the required taxes were paid.

Retirement plan distributions

Usually, if funds are drawn from a retirement plan, they will be taxed at the ordinary income rate of the investor. 

Should the investor be younger than 59.5 and therefore making an early withdrawal from a qualified plan, there are additional fees to pay.

This comes in the form of a 10% early withdrawal penalty. 

When the participant of the plan reaches 70.5, distributions should begin by April of the following year.

Margin expenses

Another tax-deductible expense is that of margin interest. 

Buying municipal securities is the one exception when dealing with interest expenses. 

Margin interest expenses for municipal securities cannot be deducted and that’s because municipal interest income is exempt from federal taxation.

Interest expenses that investors incur can be deducted if the investor has purchased securities using borrowed money to do so with a proviso.

And that’s the fact that net investment income must not be exceeded by those interest expenses.

This includes all dividends, interest income, and any capital gains made. 

Effective tax rate

Don’t confuse marginal tax rate with effective tax rate.

Marginal tax rate is paid on income received (each dollar in fact) while effective tax rate is based on the total taxable income of an investor and refers to the overall rate paid on that. 

Taxation of estates

Based on value at death, a federal tax is imposed on a decedent’s estate. 

No federal tax is charged if an individual has transferred an amount (which can be unlimited) to a spouse as long as they are a citizen of the U.S and this is known as a marital deduction. 

There are no tax implications if an individual chooses to transfer an unlimited amount or even property to an eligible charity. 

In this section, we need to talk about taxable estate vs gross estate

There’s a formula that’s used to calculate federal estate tax and the first critical component of that is gross estate.

This is all of an individual’s property interests owned at the time of their death. 

When calculating gross estate, this will include all property transferred to a charity or a spouse too, even though these aren’t normally subjected to federal tax.

To arrive at the adjusted gross estate (AGE), there are numerous expenses that need to be taken off. 

AGE includes charitable contributions, funeral expenses, and decedent debt. 

The taxable estate is the final figure to come to and you’d arrive at this by taking unlimited charitable and marital deductions off the AGE amount. 

We also need to consider alternative valuation dates

Estate executors can opt to value estate assets either at the date of death, or if they choose, six months down the line. 

When the estate includes assets that following the death of the deceased have seen their value drop, this is particularly beneficial.

As long as it represents fair market value, the sale price of an asset will be used by the executor if it was appraised at the date of death and then sold for a different price. 

What about the payment date of estate taxes?

Well, it doesn’t matter if an alternative valuation date or the date of death is used or not, it’s nine months after the death that estate taxes will become due. 

Extensions are possible, however. 

Estate income taxation

Estates could still earn interest and even capital gains during the time it takes for them to be liquidated.

In this case, this income is taxed in the same way that a trust is taxed while the income must always be reported.

Obligations related to gift tax

When property is transferred during the lifetime of a donor, gift tax will come into play. 

As of 2019, gift tax won’t be incurred for a value of up to $11.4 million during a lifetime. 

Also, $15,000 per annum can be gifted to any number of individuals without incurring federal gift taxes. 

For a married couple joining together in a gift, this can be $30,000 per person per gift. 

Gifts between spouses, however, are different. 

For those who are U.S. citizens, an unlimited exclusion exists on these gifts.

If the spouse is not a U.S. citizen, however, up to $155,000 can be gifted. 

F. Retirement plans

Let’s talk about retirement plans as this is something that’s important to all investors. 

There are so many ways to plan for retirement and we are going to cover some of the most popular. 

Traditional IRAs

The maximum tax-deductible annual contribution for an IRA is:

  • $6,000 per individual
  • $12,000 per couple 

Any capital gains or income earned is not taxed until the point that the individual opts to withdraw them.

The following are considered compensation for the purpose of IRAs:

  • Wages
  • Salaries
  • Tips
  • Commissions
  • Bonuses
  • Income derived from self-employment
  • Alimony from divorce decrees (pre-2019)
  • Combat pay that is nontaxable

These are not considered compensation for the purposes of IRAs:

  • Capital gains
  • Dividend income
  • Interest income
  • Pension income
  • Annuity income
  • Child support received
  • DPPs passive income
  • Alimony from divorces (post-December 2018)

Catch-up IRA contributions

For people aged 50 and up, catch-up contributions can be made to their IRAs (both traditional and Roth). 

This goes over and above the maximum annual contribution limit allowed.

In doing so, they can therefore save more for their retirement.

The amount allowed is $1,000.

Contributions towards a traditional IRA can be made by taxpayers that are younger than 70.5 and who report income during a given tax year.

A spousal IRA can also be opened if one spouse has earned no income (or very little) and together with their partner, they file a joint return. 

As for contribution limits, well they are the same as other IRAs.

Excess contributions

If excess contributions are made during a year, a 6% penalty tax will apply.

The owner of the IRA does have a leeway to remove these contributions, however, but must be done so by the time they file a tax return or not later than mid-April. 

Roth IRAs

Roth and traditional IRAs have many of the same characteristics, so in this section, let’s focus more on their differences. 

Here, the biggest deals with contributions and withdrawals and how they are taxed 

Unlike traditional IRAs, Roth IRA contributions aren’t tax-deductible. 

This means that earnings can be tax-free instead of simply tax-deferred.

Five years following their deposit, earnings can be withdrawn tax-free as long as:

  • The holder of the account is older than 59.5
  • The first-time purchase of a principal residence is what the money withdrawn is used for
  • The account holder has become disabled, or
  • The account holder has died

Roth IRA contribution limits

While the contribution limits for both traditional and Roth IRAs are the same, there is one significant difference to note.

As long as the taxpayer has earned some form of income, a Roth IRA allows them to make contributions past the age of 70.5.

Can someone contribute to both of these IRAs?

To that, the answer is yes, but the combined contributions cannot exceed $6,000 for those under 50 and $7,000 for those over.

What are the eligibility requirements for Roth IRAs?

Well, based on income earned, there are some limits placed on eligibility.

As long as an individual’s adjusted gross income (AGI) is lower than a specified income level, they can open a Roth IRA.

Here’s the figures:

  • AGI of less than $122,000 for a single person allows for a full amount contribution
  • AGI of between $122,000 and $137,00 will see a phasing out of the individual’s ability to contribute
  • AGI of $193,000 for married couples posting joint tax returns
  • AGI of between $193,000 and $203,000 will see a phasing out of the couple’s ability to contribute

Converting traditional IRAs into Roth IRAs

Individuals who hold a traditional IRA can convert it into a Roth IRA should they choose to do so but there are tax implications.

When a conversion takes place, the investor’s ordinary income will have the entire converted amount added to it.

For those under 59.5, an 10% early distribution tax penalty can be avoided if the funds are transferred from trustee to trustee or rolled over within 60 days if distributed to the owner. 

Withdrawals: Traditional IRAs

If an individual doesn’t want to suffer a penalty for withdrawal from their IRA, they must wait until they turn 59.5 to do so. 

Should they wait, however, by the time they turn 80.5, withdrawals have to start by April 1 of the next year.

Withdrawals will be taxed as ordinary income as they are from tax-deductible contributions. 

It’s different, however, when there are both non deductible and deductible contributions.

Should this be the case, a formula will be used.

This sees some of the withdrawal representing a nontaxable return of principal is represented by a withdrawal portion.

Early withdrawal penalties of 10% will have to be paid for those made before the age of 59.5 unless they are because of:

  • Death
  • Disability
  • Buying a primary residence for the first time ($10,000 maximum for a lifetime)
  • Expenses for qualified higher education for immediate family 
  • To cover some types of medical expenses

For a non qualified/taxable Roth IRA distribution, the same exceptions apply.

Withdrawals can be made without penalty before the age of 59.5 using the substantially equal periodic payment exception (SEPP) under IRS rule 72 (t).

This states that early withdrawals are not subject to penalty if the individual receives IRA payment based on their life expectancy at least annually. 

Nondeductible capital withdraws

Should after-tax dollars be contributed towards an IRA and later be withdrawn, these are not taxed.

Funds that result in investment gains or income, however, will be taxed at the ordinary rate when withdrawn.

IRA characteristics

Let’s look at some characteristics of IRAs that you should know about.

It is as self-directed plans that IRAs are usually set up at security firms.

Their funds are then used to buy various types of investments from stocks to bonds but also including mutual funds, REITs, UITs, U.S. government securities, and more. 

While the age and risk tolerance of the IRC should always be reflected in IRA investment, they are usually fairly conservative and always managed with long-term growth in mind.

There are many ineligible investments that IRAs shouldn’t be investing in. 

This includes collectibles, for example, but also rare coins, gems, artwork, and others. 

Also, IRAs cannot purchase life insurance contracts. 

While they are generally considered inappropriate due to low yields, tax-free municipal bonds, municipal bond funds, and municipal bonds are eligible.

There’s just better options out there for IRAs to invest in.

The following are considered ineligible investment practices for IRAs.

  • Speculative option strategies
  • Short selling stock
  • Margin account trading

Covered call writing is possible.

What about real estate investments in an IRA?

Well, this is allowed for both IRA or as a 401 (k) plan participant but it doesn’t happen often.

That’s because, when making real-estate investments, a lot of extra precaution needs to be taken. 

Do it wrong and major tax problems could arise. 

As for moving IRAs, well there are three methods that investments can be taken from one to another. 

  • Direct rollover: This sees a distribution to a traditional or Roth IRA from an employer-sponsored plan.
  • 60-day rollover: Here, the owner of the IRA can move it to another custodian and can do so once every 12-month period. 
  • Transfer from trustee-to-trustee: Here the funds in an IRA are moved directly in what is known as an IRA transfer. This takes place from one custodian to another. 

IRAs that are inherited

Whether the person inheriting the IRA is a spouse or some other relative will guide the rules that are applied to that inheritance. 

Let’s look at a spousal beneficiary.

Two decisions need to be made in this regard:

  • The amount of the IRA inheritance can be included in the spouse’s IRA. This is called a spousal rollover (normal rules governing IRAs apply)
  • Leave the IRA as is but take ownership as a beneficiary (there is no 10% penalty for an early withdrawal. RMDs, however, must start at the point that the deceased would have had to start receiving  them)

Next is a nonspouse beneficiary

Those who are not spouses of the deceased have a few options.

They can:

  • Take the cash immediately
  • Cash the IRA out in 5 years
  • Take out RMDs over their own life expectancy

IRA disclaiming

Occasionally, those receiving an IRA as a beneficiary of the deceased won’t want it.

For the exam, you should know what happens when the proceeds are disclaimed.

This will see the assets pass on to another person, usually called the contingent beneficiary. 

Qualified and unqualified retirement plans

Let’s start with employer-sponsored qualified retirement plans. 

Keogh plans

These are ERISA qualified plans aimed at those that are self-employed or unincorporated businesses with owner-employees, basically anyone who pays Social Security self-employment taxes. 

When compared to an IRA, Keogh plan contributions are higher. 

As of 2019, plan participants can contribute as much as $56,000.

For the plan to be nondiscriminatory, the contribution percentage between the business employees and the owner must be the same.

It’s possible for an individual to hold a Keogh plan as well as an IRC, but the IRA contribution will not be deductible if earning limits are exceeded. 

The following employees are eligible for a Keogh plan:

  • Full-time employees (who are paid for at least 1,000 hours worked per annum)
  • Tenured employees (with one or more years continuous work)
  • Adult employees (between 21 and 70.5)

Keogh and IRAs have many similarities:

  • Contributions to these plans are tax-deferred
  • They are tax-sheltered until withdrawal
  • Contributions are cash only. Rollovers allow deposits of cash and securities, however
  • Distributions can take place from 59.5 without penalties
  • Early withdrawal results in a penalty (10%)
  • Payout options included a lump sum or periodic payments
  • A beneficiary (or beneficiaries) will receive payments should the plan holder die

403 (B) Plans

These tax-deferred retirement plans are for public school system employees as well as churches, charities, and other tax-exempt, nonprofit organizations.

As long as limits aren’t exceeded, employees can exclude contributions from their taxable income.

Because these are to encourage retirement savings, any withdrawals before 59.5 will be subject to tax penalties.

A 403 (b) plan provides the following tax advantages:

  • Contributions are not included in gross income
  • Until distributions, earnings grow tax-free

The eligibility requirements for a 403 (b) plan mean that employers must qualify as either:

  • A religious organization
  • A 501 (c)3 tax-exempt organization
  • A 403 (b) public institution

All employees of these organizations qualify.

The definition of an employee in this regard is someone 21 or older who has finished a year of working at the organization.

Contributions to the plan for workers are in the form of a salary reduction that’s taken off before taxation. 

For the employer contributions, it’s the lesser of either $56,000 per annum or 100% of the employee’s compensation.

Retirement plans: Corporate sponsored

There are many types of corporate sponsored retirement plans, from 401 (k) to profit-sharing and pension plans.

Defined benefit and defined contribution plans

If a retirement plan is considered to be qualified, it will be from one of two categories:

  • Defined contribution plans: These focus on current contributions that are tax-deductible but don’t have a specific end result
  • Defined benefit plans: Thes don’t have a specific level for current contributions but do have a defined retirement benefit

Let’s look at defined contribution plans first and they include 401 (k) plans, money-purchase pension plans, and profit-sharing plans. 

Here, an employer’s maximum contribution is like an IRA and set at $56,000.

The value of these plans at retirement will depend on how much was contributed to them as well as funds generated through plan investments that result in interest and capital gains. 

Deductions for these plans to eligible employees who have joined the plan can not be over 25% of the annual payroll. 

Then there are defined benefit plans

These provide certain retirement benefits,

This could be monthly payments after retirement or a lump sum straight up. 

Under the contract terms of the plan, the benefit is always paid no matter how the plan performed from an investment point of view.

That’s because the investment risk is always taken on by the sponsor of the plan. 

Profit-sharing plans

This type of plan sees employees of a business take part in the profits it generates and it’s established by the employer themselves.

Benefits can either:

  • Be paid to employees
  • Put into an account for payment at some point in the future
  • A combination of both of the above

As per the Internal Revenue Code, to be qualified, this type of plan must have contributions that are both substantial and recurring.

401 (k) plans

These are extremely popular and see an employer take off a percentage of the salary of their employees.

This is then used as a retirement account contribution with the employer matching it with pretax dollars used for both. 

Roth 401 (k) plans

Certain Roth features can be added to 401 (k) plans by employers with these plans needing contributions that are after-tax but providing withdrawals that are tax-free (if the person is 59.5 or older and if the account is 5 years or older).

Those contributions made by the employer have to be paid into a regular 401 (k) plan.

At withdrawal, they are fully taxable.

This means that employees have both a regular 401 (k) and Roth 401 (k) account and they can choose to contribute to either.

Money cannot be transferred between them, once contributed. 

When it comes to who can participate in these plans, there are no income restriction limits.

Withdrawals will have to take place by no later than 70.5, which is unlike a Roth IRA.

Section 457 plans

Set up under section 457 of the tax code, these are deferred compensation plans. 

These are used by states, their political subdivisions, and agencies, and can be offered to hospitals, unions, and charities, for example.

Compensation can be deferred by employees if they wish and they will receive a deduction each year based on that.

SIMPLE plans

When a business has fewer than 100 employees who earned $5,000 or more the previous calendar year, they can opt for a Savings incentive match Plan for Employees (SIMPLE).

Easy to set up and run, SIMPLE allows for an employee contribution of up to $13,000.

There is a catch-up provision of $3,000 as well. 

The employer can match this in two ways:

  • With a 2% non-elective contribution (this is 2% of a participating employee’s compensation up to $280,000). This doesn’t matter if an employee chooses not to contribute themselves.
  • Dollar-for-dollar matching contributions up to 3% of compensation but only to employees that contribute themselves.

That’s it for qualified plans but we still need to cover those considered as nonqualified. 

When a plan is nonqualified, when an employer makes a contribution, they are not allowed a current tax deduction.

When the money is paid out to the employee, the tax deduction will come through to the employer.

The nondiscrimination rules that apply to qualified plans aren’t in effect here either. 

Let’s look at other elements you should know about these plans.

Taxation of nonqualified plans

We’ve already mentioned an aspect of taxation above when it comes to these plans. 

They can be designed in such a way that until the benefit is received by the employee, contributions aren’t taxable anyway.

The investor’s cost base is made up of already taxed contributions to these plans.

The cost base won’t be taxed when the investor takes money out of the plan but earnings will be.

Types of nonqualified plans

There are three types of nonqualified plans:

  • Payroll deduction plan
  • Deferred compensation plan
  • Retention (or supplemental executive retirement) plan

When we compare a qualified to nonqualified plans remember the following:

Qualified plans:

  • Tax-deductible contributions
  • IRS approved
  • Nondiscrimination against who can join
  • Subject to ERISA
  • Tax-deferred on accumulation
  • Withdrawals taxed
  • The plan is a trust

Nonqualified plans

  • Non-tax deductible contributions
  • No need for IRS approval
  • Discrimination against those who can join is possible
  • Not subject to ERISA
  • Tax-deferred on accumulation
  • Taxation on excess over cost base
  • The plan is not a trust

G. Issues with Erisa

The Employee Retirement Income Security Act (Erisa) provides guidelines for retirement plan regulation which include:

  • Eligibility
  • Funding
  • Vesting
  • Communication
  • Nondiscrimination

Note that it’s only for corporate plans that ERISA regulations apply and not public sector plans. 

ERISA fiduciary responsibility 

Erisa had a long line of trust laws to help it because most retirement plans are set up as trust agreements.

As stock markets grew in the 1960s, there were major changes in the investment practices of fiduciaries.

For this reason, the Uniform Prudent Investors Act (UPIA) was promulgated to update trust investment laws. 

In terms of prudent investing, the UPIA made the following changes:

  • It’s to the total portfolio that the standard of prudence must be applied
  • A fiduciary’s prime concern is the trade-off between risk and return
  • There was a removal of all categorical restrictions on investment types
  • Diversification forms part of prudent investing
  • Delegation of investment functions, subject to certain safeguards, can take place 

We need to mention Section 404 of ERISA

Section 404 details regulations specifically for retirement plan fiduciaries. 

If acting in this capacity for an employee benefit plan, all responsibilities must be carried out in line with the document specifications of said plan. 

ERISA doesn’t allow fiduciary duties to be delegated by trustees.

Trustees, however, can look to a qualified investment manager to handle investment management responsibilities. 

Also let’s briefly mention the Investment policy statement (IPS)

All employee benefit plans should have an IPS although it is not mandatory. 

This will act as a fiduciary standard with regards to funding and decisions regarding investment management.

An IPS will usually include:

  • Investment objectives
  • Future cash flow needs
  • Style of asset allocation and other investment philosophies
  • Criteria for investment selection
  • How performance and procedures are monitored

Erisa also defines prohibited investments

These include art, gems, collectibles, coins, and other similar objects of worth. 

You should be able to differentiate this from prohibited transactions that a fiduciary cannot carry out.

While lots of transactions are fine, those that lead to a conflict of interest are not.

This includes:

  • Transactions that use plan assets for their own interest, or those from their own account, or self-dealing
  • Acting on behalf of a party in a transaction that is contrary to the plan
  • Getting compensation to their own account for any transactions connected to the plan

Safe harbor provisions

According to Section 404 (c), a fiduciary who acted correctly in their capacity cannot be held liable for any losses the plan may incur. 

This regulation does require three conditions, however:

  • Selection of the investments
  • Control of the investments
  • Communication of relevant and required information

Summary plan description (SPD)

A SPD is sent to anyone who becomes a participant of an ERISA-covered retirement plan. 

This is an explanation of not only what the plan will provide to participants but how it operates as well.

There’s a lot of information covered here, including how benefits are calculated, when they become vested, when they are paid, and more. 

H. Special account types

Let’s look at various special accounts that you should know about, specifically education and health-related savings accounts.

Coverdell education savings accounts

Coverdell ESAs allow for student beneficiaries and contributions can be made after-tax.

These are cash only and can be made until the beneficiary turns 18 (unless they are considered special needs beneficiaries).

Here, nondeductible contributions can accumulate in a Coverdell ESA on a tax-deferred basis.

Upon distribution to pay qualified education expenses, the earnings portion will be left out of the income.

The recipient will have the withdrawn earnings taxed to them and if not used to pay for their education, a 10% tax penalty will be applied. 

A Coverdell ESA has a maximum contribution of $2,000 per annum. 

Section 529 plans

Section 529 plans also provide a way to save towards a dependent’s education and are state operated. 

They come in two forms that we will cover.

Prepaid tuition plans

This works in conjunction with participating educational facilities and lets those saving for college prepay for their tuition.

A large percentage will include residency requirements because state governments sponsor them. 

College savings plans

With these plans, an account is established by the account holder who will contribute towards it with a set beneficiary in mind.

Investment options can be chosen with this type of plan.

They include mutual funds, bond mutual funds, and money market funds. 

This type of plan has no residency requirements, so beneficiaries can attend anywhere.

529 plans and tax

529 plans provide excellent tax benefits.

They are not subjected to federal tax at all, and most won’t see contributors having to pay state tax either even though contributions are made with after-tax earnings.

Of course, withdrawals have to be for college expenses for these tax rules to apply.

If they aren’t, a 10% federal tax penalty applies.

Restrictions for withdrawals

We’ve already seen that there is a tax penalty for any withdrawals that are not education related.

No tax liability is incurred should the funds in a plan be rolled over to a member of the beneficiaries’ family.

There are rules in place that govern this, however.

Once distribution has taken place, the rollover must take place within 60 days from then. 

529 plan contributions

These plans don’t necessarily require that the beneficiary is a family member with contributions made in periodic payments or one lump sum. 

If the withdrawal is taxed, the donor to the plan has no responsibility towards it, only the beneficiary of the plan. 

A maximum of $75,000 ($150,000 if the donor is married) can be contributed to 529 plans per annum without incurring gift taxation. 

The assets in the plan remain in the control of the donor who can reclaim them if they choose.

They may incur a 10% penalty if they do, however.

An offering circular must be delivered for these plans according to the MSRB because they are seen as municipal fund securities. 

UTMA/UGMA accounts

Custodial accounts under the Uniform Gift to Minors Act were a popular way to fund a child’s education in the past. 

With this type of account, all the trades are entered by the custodian.

Both UTMA and UGMA accounts have a prerequisite that sees an adult operate as a trustee for the beneficiary of the account.

There are no limitations on these accounts in terms of what may be gifted, so any cash or security is fine.


Before the minor associated with the account reaches maturity, the custodian manages the UTMA/UGMA account.

This means they can:

  • Purchase or sell securities
  • Opt to exercise warrants or rights
  • Hold, trade, or liquidate securities

Custodians have a fiduciary responsibility when dealing with these accounts and they include certain limitations:

  • They are operated only as cash accounts
  • Securities cannot be bought on a margin
  • Securities cannot be used as loan collateral
  • All cash proceeds, interest, and dividends generated must be reinvested
  • The minor’s age and custodial relationship must always be considered in investment decisions
  • Rights/warrants must be sold or exercised

Custodians can be reimbursed should they have incurred reasonable expenses while carrying out their management duties on these accounts.

Securities can be donated to a minor under the laws governing these accounts.

When this is carried out, the rights to those securities are no longer that of the donor and they cannot take the securities back. 

Custodian/minor death

A court will appoint a new custodian should the one who established the account die.

If the minor dies, the account securities will enter their estate.

They do not pass on to their parents/guardians.

UTMA unique features

There are many similarities between UTMA/UGMA accounts, but you should note the differences.

UTMA accounts can hold real property, including some types of partnership interest as well as certain intangible properties, while UGMA accounts cannot.

This means when it comes to investment choices, there’s lots more on offer with an UTMA account.

UTMA accounts can also be delayed in terms of when they are transferred to the minor.

This doesn’t have to happen at their age of majority. 

Health savings accounts

These accounts are used to pay for medical expenses. 

They have numerous benefits:

  • Tax deductions can be claimed for contributions
  • HSA contributions by an employer may be left out of gross income
  • Until used, the contributions will remain in a person’s account
  • Interest or other earnings that are generated remain tax-free
  • When paying for medical expenses, distributions are tax-free
  • HSA’s can be carried across when changing employment

HSA eligibility

The following requirements must be met:

  • Individuals will need to be covered as part of a high deductible health plan
  • Unless permitted under HSA rules, individuals can have no other health cover
  • Individuals may not be part of Medicare
  • Individuals cannot be listed as a dependent on the tax return of someone else
  • Joint HSAs are not allowed

HSA contributions

Individuals are allowed to contribute to a HSA and if part of one is provided by an employer, both parties will contribute. 

While investments can be made into mutual funds, bonds and stocks, contributions to HSAs, by law, must be made in cash. 

Property and stock can never be used as contributions. 

I. Estate planning techniques

There are some basic concepts regarding estate planning that you should know for the exam but in particular, TOD accounts. 

TOD accounts

Upon a client’s death, to keep assets that are in a brokerage account from becoming subject to probate, the simplest way to do so is with a transfer-on-death account. 

This also allows that the account owner’s wishes are followed in how they are distributed. 

Where state taxes are applicable, however, TOD accounts cannot escape them. 

Most kinds of paper assets include TOD account options.

For example, this includes savings and checking accounts, stocks, bonds, CDs, and other types of securities. 

The rights to the property are for the owner only, while they are alive. 

The named beneficiaries will have the property transferred to them immediately. 

Owners, while alive, can change beneficiaries as they see fit. 

They can also decide on an unequal distribution of assets. 

As for legal parameters, one of the reasons TOD accounts are popular is because they have no legal document requirements. 

The following accounts can be opened with a TOD designation:

  • Individual accounts
  • JTWROS accounts
  • Tenants by the entirety accounts

J. Trading securities

Trading securities is a large part of your job, so let’s look into how that all works.

Margin and cash accounts

When customers look to open an account, they have two options: margin or cash.

The choice ultimately comes down to how they will pay for the securities they buy.

So in a cash account, securities bought are paid with the full purchase price on the settlement date.

Margin accounts allow customers to borrow a section of the purchase price.

This is set out as per the Federal Reserve Board’s (FRB) Regulation T.

Let’s look at cash accounts a little closer.

These are the most basic investment accounts and available to anyone eligible to buy securities. 

For the exam, you should know that some accounts may only be this type of account and these include:

  • IRAs and other personal retirement accounts
  • Corporate retirement accounts
  • UTMAs and other custodial accounts
  • Coverdell ESAs

Margin accounts are a little more complicated.

Here less money can be used by customers controlling their investments when compared to cash accounts.

This is because of the borrowing involved.

The minimum amount of cash a customer must deposit to buy securities is what the term margin refers to. 

There’s another aspect, however.

That’s because a customer can use their margin account as a means for cash.

This happens if they have an account with fully paid up securities in it. 

Should they need cash, the broker-dealer will lend it to them based on the value of the securities and up to a margin limit as set by the FRB.

Not just anyone can open a margin account and those that do will need to meet certain suitability requirements. 

Financial leverage is used when buying on a margin.

This means that the chance for potential gain (and loss) are greater through the use of borrowed funds.

What about marginable securities?

The securities that can be used as loan collateral, as well as those that can be bought on margin, are highlighted by Regulation T. 

Securities that can be used as collateral or purchased on a margin include:

  • Stocks and bonds that are exchange-listed
  • Nasdaq traded stocks
  • Warrants traded on both the Nasdaq and other exchanges

Certain securities can be used as margin collateral if they have been owned for 30 days or more and include:

  • New issues
  • Mutual funds

There’s a few important documents needed for margin accounts.

The main document is the margin agreement, but this includes two supplementary documents:

  • Credit agreement: This will highlight the credit terms and establish the debtor/creditor terms between the firm and the customer
  • Hypothecation agreement: This signifies that the client has given the firm permission to use their securities as collateral.

A third document, in the form of a loan consent, is optional. 

If signed, the client has given the firm consent to use their securities and lend them to other brokers. 

Quotes, bids and offers

In this section, we look at specific terminology that’s used when securities are traded. 

A current bid and offer on a security from a market maker is known as a firm quote

The highest price that a dealer will purchase is known as the current bid, and the lowest price that dealers choose to sell as security at is simply called the current offer

The spread is then the difference between the bid price and the ask price. 

A narrow spread is associated with a stock that is active, while a less active stock will have a wider spread between the bid and ask price.

When a market maker presents a quote, the number of shares on offer is included. 

This is known as the size. 

Should the size not be included, the quote is then for what is known as a single round lot.

This is 100 shares. 

Order types

Let’s talk about the types of orders you will come across when trading securities. 

You can easily see what the order is by looking at the order ticket.

According to regulations, before an order entry is made, the order ticket must be prepared and this means it will require the following disclosures:

  • Account number
  • If the order is discretionary, solicited, or unsolicited
  • When it’s a sale, if it is long or short
  • It the order a stop, limit, or market order
  • The shares (if stock) or aggregate par value (if a bond)
  • Order entry time
  • Broker-dealer name and the registered individual who accepted the order


There are orders that will restrict a transaction’s price and they include:

  • Market order: There are no restrictions and it is at the market price that this is executed immediately
  • Limit order: The amount paid or received for the securities is limited by this order
  • Stop order: Should the stock reach or go through the designated stop price, this order becomes a market order 
  • Stop limit: Initially entered as a stop order, should the stock reach or move through the trigger price, this will become a limit order


Some orders will restrict transaction prices and they include:

  • Day order: If not filled by the end of the day, this order will expire
  • Good till canceled (GTC) order: Until this order is either filled or canceled, it will not expire


Whichever is less than $200,000 or 10,000 shares is defined as a “block” according to a NYSE rule.

Now let’s look at the various orders and expand on them.

Market orders

There are no restrictions on these orders.

That means that as soon as they are received, they are executed immediately and this occurs with them being sent to the trading floor.

This order will always be processed before any others because it has priority.

When executed, a market order is always carried out at the lowest market price when buying and the highest bid price when selling.

A market order will guarantee execution if a security is in trade.

Limit orders

With this order type, the purchase or selling price is limited to the level the customer wants. 

So only if the specified price (or a better one) can be found will the order be executed. 

So in a buy order, a better price means lower than that set by the customer, and in a sell order, higher.

Should the order not be executed immediately it can be left in the order book to be executed when the order price is met by the market price of the security in question.

There are a number of risks and disadvantages associated with limit orders

Firstly, when used, the customer is running the risk of bypassing the chance to buy or sell the security in question. 

This can easily happen when the market moves a distance from the price set out in the limit order.

Stop orders

If a client wants to protect a profit or avoid a loss should stock prices move in the opposite direction to what they want, they would use a stop order.

When the stock price goes through a price set out by the client, the order is then executed.

This price is known as the stop price.

When this happens, stop orders become market orders.

There are two trades that need to happen or a stop order to be executed:

  • Trigger: The trade is activated when the trigger transaction occurs at or through the stop price
  • Execution: This is when the stop order moves to a market order and the trade is then completed when it is executed at the market price

There are a few categories of stop orders that you should know about.

First, there is the stop limit order that becomes a limit order instead of a market order when triggered.

Second, there is the buy stop order which, if a client holds a short stock position, will help either limit a loss or protect a profit.

When entered, a buy stop order will always be above the current market. 

It’s executed as soon as the market price reaches that point or goes through it. 

Third, there is a sell stop order too and this works in the same way but is protecting a long stock position. 

High frequency trading and dark pools

High frequency trading (HFT) is something that’s beginning to dominate stock markets as it’s a technique that has risen in popularity over the last decade. 

In U.S. equity markets, HFT is responsible for over 50% of all the trades made. 

But what is it?

Well, HFT is trading by computers that use high speed connections to exchanges and looks to utilize them to make quick profits.

Here, by taking advantage of the small discrepancies in pricing at various exchanges and by trading on them in massive quantities quickly, profits can be made.

While this does make markets efficient, regulators do have their concerns as on the whole, because of HFT, financial systems do show more fragility. 

HFT benefits

These include:

  • Market liquidity increases. This applies especially to stocks that trade actively
  • The efficiency of the market increase and this means narrower spreads
  • Costs are reduced. This is especially true for mutual funds and other institutional purchasers

HFT negatives

These include:

  • Markets can be manipulated because of the sheer volume of HFT trades. For example, trades can be entered and canceled. This can generate market activity that would not have necessarily have happened in the first place
  • Small investors are affected as they don’t have access to the trading information at the same time as HFT traders. Remember, it’s computer systems that are analyzing the markets and then carrying out HFT trades based on the information. This happens in a matter of seconds. 
  • HFTs have a snowballing effect because of their great volumes and this can impact the market greatly

Dark pools

Dark pools offer trading volume that’s not available to the investing public in general.

In other words, the trading that takes place here occurs away from exchange desks and is carried out by trading desks and institutional traders.

Here, alternate trading systems or crossing trading networks see large volume transactions. 

These systems will look to match up buy and sell orders and then execute them.

This all takes place electronically and without the need for the order to be routed through a market or exchange. 

Regulators have various concerns about dark pools.

For one, market participants that don’t use them are at a disadvantage.

This is because they have no way to see the trades that take place and don’t know important details, like the price that the stock was bought or sold for. 

This means that markets aren’t as transparent as they should be.

In the U.S. stock market system, around 17% of trading is in dark pools. 

Market participants and the costs of trading securities

In this section of the exam, you may encounter questions that deal with the various market participants as well as the cost of trading securities.

This is something that you will have knowledge of already, so we aren’t going to go into it in great detail.

Instead, let’s highlight what the NASAA content outline for the exam says you should remember.

When it comes to market participants, you should know how these operate and include:

  • Broker-dealers and the role they play
  • The role of custodians
  • The role of market makers

You should also understand how exchanges operate when trading securities.

As for the cost of trading securities, the following is important:

  • Commissions
  • Markups
  • How best execution operates

K. Measuring portfolio performance

How their client’s investment accounts perform is how an investment adviser’s performance is ultimately measured.

How can you go about carrying out those measurements?

Bond yield reviewing

In terms of measuring performance, one of the most important metrics is that of yield.

There are various ways in which this can be measured.

Current yield

To work out the current yield on a debt or equity investment, you can take the current market price and divide that into the annual income stream (either interest or dividends).

For a debt security, for example, when the market price of the security changes the annual interest rate won’t change as it’s always fixed as a percentage of the par value. 

So a 5% bond pays $50 in interest which is broken into two payments of $25 every six months.

Yield to maturity 

It’s only debt securities that yield to maturity applies.

This is because, at the maturity date, these securities will have a loan principal that is paid back,

A subset of yield to maturity is yield to call. 

Here, to calculate the return, the call date is used instead of the maturity date as a means to work out the return of the security.

YTC is lower than YTM, CY, and NY when the bond is selling at a premium

YTC is higher than YTM, CY, and NY when the bond is selling at a discount

Measuring investment returns

The exam will include computations for investment returns. 

Let’s look at what you need to know about this.

Total returns

This includes:

  • Dividend income
  • Interest earned
  • Capital appreciation 

Note that this is over a certain time period that these are earned and this is usually a year.

Total returns are important as a metric tool because many believe this is the easiest (and best) way to determine just how a client’s security has performed. 

We also need to mention mutual fund returns

The total return here is a little different because it may include real capital gain that’s being realized over and above the income from dividends.

The total return must include all of these added together as well as any unrealized appreciation/depreciation.

Total return in a mutual fund must be separated from current return. 

Current return calculations can only use income distributions over the last 12-month period.

This is divided by the current per share price, as laid out in SEC regulations.

Therefore current yield = annual dividend / current price.

Holding period return

When a client holds an investment for a period of time, that is known as the holding period. 

Any returns that an investment makes during that time is known as the holding period return (HPR).

While this is essentially the same as total return, that’s computed on an annual basis while the HPR can be worked out for any period you wish.

Annualized return

The return an investor will make for holding onto an investment for a period of a year is known as the annualized return. 

To work this out, you take what is known as the annualization factor and multiply it by the actual return. 

As for the annualization factor, well, take the 12 (for the number of months in a year) and divide it by the period of time (in months) that the investment was held for. 

Inflation-adjusted return

Also known as real return, this takes inflation into account.

We know how the buying power of a currency can be reduced by inflation and because of that, investment performance can be adjusted to measure the buying power of an investment. 

Real rates of returns, therefore, are those that have been adjusted in this way. 

This is a computation that will often appear on the exam. 

You must lower the nominal return of debt securities by the CPI-reflected inflation rate in order to calculate the inflation-adjusted return.

After-tax return/yield

We know that, in general, capital gains and income are taxable.

So any return on an investment is reduced due to taxation.

This return is called the after-tax return or sometimes the adjusted return. 

To work it out you can reduce the return of the investment by the tax rate of the particular client that you are working with. 

So if a return makes a 10% yield for a client in the 25% tax bracket, they will retain 75% of that yield.

Remember that  Section 529 plans and Roth IRAs offer totally tax free returns.

For a municipal bond, dividends received are tax free but if a capital gain is realized, it will be taxed. 

Probable return

As the name suggests this is what the return on an investment will likely be and it’s only an estimate. 

To work this out, you would look at each investment and assign their probable return in terms of earnings.

That return is then multiplied by the probability of this all happening. 

The expected return for the investment is then the sum of those probable returns. 

If you are a little confused, here is the formula:

Expected return = (return A x probability A) + (return B x probability B).

Risk-adjusted return

This is a method to look at a portfolio and quantify the risk associated with it and it’s sometimes called the Sharpe index.

But how does it work?

Well, it includes two elements: the risk-free rate (the 91-day T bill rate)  and the portfolio’s overall return.

All you need to do is take the overall return and subtract the risk free rate from it. 

This will give you the risk premium of the portfolio which is then divided by the portfolio’s standard deviation. 

This will tell you the amount of return per unit of risk taken.

More return per unit of risk taken will result in a higher ratio and less, a lower one.

While talking about the Sharpe ratio, we must mention risk premium too. 

If the Sharpe ratio is to be positive, the risk-free return has to be exceeded by the actual return on an investment. 

This return is the risk premium. 

A combination of the risk-free return plus a risk premium will lead to the required rate of return.

Internal rate of return (IRR)

There are three important points you should remember about IRR:

  • When measuring the return on a DPP, this is the ideal method
  • The time value of money is taken into account when using IRR
  • To compute the yield to maturity of a bond, use IRR

Let’s also consider time-weighted returns

Time-weighted returns, along with dollar-rated returns are used as a way to work out the rate of return of an investment.

But they have very contrasting aims in doing so.

With a time-weighted return, there is no regard given to the investor’s cash flow. 

So this means, in terms of performance, it evaluates over a period of time just how the investment has performed.

For a dollar-weighted approach, the investor would be the focus of the performance measurement. 

With respect to investment dollars and because investment managers aren’t in control of future cash flows, it’s time-weighted returns that are reported on most mutual funds. 

We’ve mentioned dollar-weighted returns above but let’s expand on that. 

Here, the investment and any withdrawals or deposits are what’s considered and an example of this would be the sale of stock.

As mentioned, the return of the investor and not the investment is therefore the focus over a certain period.

When compared to the time-weighted method the result is a rate of return that’s different. 

Portfolio benchmarks

We know that various indexes, such as the S&P 500, are used as benchmarks when it comes to measuring performance in both the overall market or sectors thereof.

Because they are weighted for capitalization, indexes will see a greater effect when the stock price of a large company changes. 

They can also be used as a benchmark when it comes to portfolios that have their performance gauged against them. 

Don’t forget mirroring either.

Here, ETFs and index mutual funds buy securities that will mirror the performance of a certain index. 

Let’s look at some of the indexes that could appear on the Series 65 exam. 

  • Dow Jones Industrial index (DJIA)
  • Standard and Poor’s 500
  • New York Stock Exchange Index
  • Nasdaq Composite Index
  • Russell 2000 Index
  • EAFE
  • The Wilshire 5000

Of all these indexes, only the Dow Jones Industrial Average is a price-weighted average, the others are cap-weighted.

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