Series 7 Study Guide Navigation
- Series 7 Study Guide Home
- 1.1 Contact with potential and current customers, marketing material development, approval, and distribution
- 1.2 Describing investment products to potential and current customers
- 2.1 Tells potential customers about the account types available and discloses their restrictions
- 2.2 Secures and updates information about customers along with relevant information and documents
- 2.3 Gather customer investment profile information
- 2.4 Get necessary supervisory approval to open accounts and make account changes
- 3.1 Passing on all investment strategy information to customers
- 3.2 Analyze customer’s portfolio of investments as well as product options to determine suitability
- 3.3 Disclose to clients characteristics and risks of investment products
- 3.4 Communications with customers
- 4.1 Providing current quotes for investors
- 4.2 Processing and confirming customers’ transactions as per regulations
- 4.3 Notifies the correct supervisor, helps with solving discrepancies, disputes, errors, and all complaints
- 4.4 Dealing with margin issues
Tells potential customers about the account types available and discloses their restrictions
Customer account types
We begin with the different customer accounts available.
The most common are:
- Cash accounts
- Margin accounts
There are others that we will cover too.
When we talk about a basic investment account, a cash account immediately springs to mind.
That’s because it’s available to anyone.
Should investors with a cash account buy securities, they have to pay in full.
It’s important to note that certain types of investment accounts can only be cash accounts.
- IRAs and other personal retirement accounts
- 401k and other corporate retirement accounts
- Uniform Transfer to Minors Act, Coverdell Education Savings Account (ESA), and other custodial accounts
Margin accounts differ as customers who have them can use both cash and credit to purchase securities.
Financial leverage is the term used to describe the use of borrowed money for the purchase of securities.
For the most part, credit is superior to cash as it allows investors to purchase more securities unless, of course, they have the cash readily available.
And that’s not an option with most new investors trying to get into the game.
The credit to purchase extra securities comes from the securities firm.
The collateral for the loan is covered by the securities in the portfolio.
In the investment world, this is known as purchasing securities on margin where the margin is the lowest amount of equity needed to buy the securities.
The difference between the amount of cash put in and the purchase price of the securities to be bought is the loan amount that is covered by the securities firm.
Like all loans, there is an interest cost on the loan amount provided.
Of course, a loan is a debt and it’s going to have to be repaid at some point.
That’s why margin accounts are considered riskier when compared to cash accounts.
That risk leads to those who want to open a margin account having to meet certain suitability criteria.
Also, more risk means retirement or custodial accounts, which cannot include any margin transactions.
Investment firms provide investors with a fee-based account option in many circumstances.
This doesn’t use commission-based charges for their brokerage services.
Instead, clients pay a single fee for the firm’s services.
This fee can be either a percentage of the client account’s assets or fixed.
But fee-based accounts aren’t for all investors.
FINRA regulations state that it’s aimed at those who trade at a moderate level in terms of activity.
If an investor does open a fee-based account, according to regulations, they must be given a disclosure document.
This should explain the cost of the services that will be provided to them concerning their fee-based account.
Fee-based accounts have an advantage in the fact that they help reduce churning and other abusive sales practices.
This is when there is excessive buying and selling on a customer account to generate commissions.
Obviously, as commissions are part of a fee-based account, this cannot happen.
They are susceptible to reverse churning, however.
This sees low-trading customers being advised to change from a commission-based account to a fee-based one even though it won’t benefit them and the costs are higher.
Don’t get fee-based accounts confused with wrap-fee accounts either.
Accounts in which firms provide a group of services are known as wrap accounts.
Services could include portfolio management, administration, asset allocation, and executions.
Any broker-dealer offering this kind of account must register as an investment adviser as well.
Prime brokerage account
With a prime brokerage account, an institution will choose the prime broker (or FINRA member firm) to perform several services for it.
- And other related services
Executing brokers, however, will carry out the customer trades as placed by them.
When opened, a prime brokerage account includes an agreement between the prime broker and this customer.
This will highlight the specific terms and include the name of executing brokers as used by the customer.
These executing brokers and the prime broker then enter written agreements.
The customer will receive all statements, trade confirmations, and other correspondence from the latter as they oversee securities transactions’ clearance and settlement.
Note that the executing brokers must comply with trading rules in a situation like the one described above.
A prime brokerage has one key advantage for an investor.
That’s the ability to make use of numerous brokerage houses in their trading but have the benefit of their account administration handled by a prime broker, including all their securities and cash.
Prime broker accounts also offer a range of specialized services.
- Cash management
- Trade processing
- Margin financing
- Securities lending
- Operational support
Receipt vs Payment (RVP) and Delivery vs Payment (DVP)
What are RVP and DVP payments?
Well, with this arrangement, if securities are purchased, payment for them is made to the customer agent of the selling party, and/or the buying customer’s agent receives delivery of the securities in return for payment at settlement time.
This cash-on-delivery settlement is used for institutional accounts.
The arrangement between the bank/depository and the customer must be verified by the broker-dealer involved in the trade.
Each purchase or sale requires that the bank/depository be notified by the customer.
Pattern day trading account
Someone that buys and sells more securities on the same day is called a pattern day trader.
To be considered one, an investor over a five-business day period must carry out four and above day trades.
But there is a minimum entity requirement that must be met as well.
And that’s $25,000 which must reflect in the account equity whenever they choose to day trade.
Should a member firm want to include day trading as part of their services, some admin duties must be carried out before opening day trading accounts for clients.
This includes a risk disclosure statement being provided for all new day trading customers.
This must highlight the risks associated with this kind of trading.
Registration of accounts
When an investor opens an account at a broker-dealer, there are numerous registration types to choose from.
- Individual accounts
- Multiple owner accounts
Within the multiple owner accounts, there are even more options to choose from.
This is pretty self-explanatory.
Only one owner is involved with an individual account and only they can:
- Handle account investments
- Have cash or securities distributed from the account
It’s on the individual alone that suitability is based.
Multiple owner accounts
A range of account types can have multiple owners.
Here, there are two or more people that act as co-owners of the account.
Because they are co-owners, the participants in the account all have some form of control over it.
Starting a joint account will need the signatures of all the participants but it will also require that a joint account agreement be signed as well.
Those who participate in a joint account are known as tenants.
All tenants have to sign the securities certificates should they be sold from a joint account.
What about the suitability requirements for a joint account?
Well, investment advisers are governed by much the same rules that cover other account types.
For example, what the client wants should always be at the forefront of anything.
Investment advisers need to remember that they are dealing with more than one owner, so it’s critical that they all form part of the decision-making process when it comes to securities.
And the information that an adviser can get from these individuals can help guide them in their recommendations, as long as it’s for the good of the group and not one individual.
JTWROS – Joint tenants with rights of survivorship
JTWROS ownership deals with the interests of a tenant who has passed away.
And basically, it means that a surviving tenant receives the interest in the account from the deceased tenant.
This type of account is often seen with married couples and with them, ownership is equal for both parties.
TIC – Tenants in Common
With a TIC account, which are most commonly used between relatives that aren’t your spouse or friends, the fractional share of a deceased tenant in a TIC account will be given to their estate.
Ownership in these accounts can be unequal and a TIC account need not be only for two individuals either.
Not recognized by all states, community property is a property classification associated with marriages.
In the states where it is active, community property states that during the marriage, anything property acquired by the couple is jointly owned.
Should there be a divorce for example and that property is sold, the proceeds from that sale should be divided equally.
Community property doesn’t just come into play with divorce, however, but also with marriage annulments and death.
In these states where community property is active, joint ownership is presumed automatically.
There are some exceptions, however, including inheritances, gifts, as well as property owned before marriage.
To confuse matters, some states have slightly different community property laws.
For example, in some, the law is comparable to joint other property designations like joint tenancy with rights of survivorship.
This is known as community property with rights of survivorship.
While they have two names on the account, a custodial account is not technically a joint account because there is only one owner.
These two names belong to the beneficial owner (a minor) and the custodian of the account.
Originally, the format for these accounts fell under the Uniform Gifts to Minors Act (UGMA) but now it falls under the Uniform Transfer to Minors Act (UTMA) that replaced it in all but one state.
These accounts are necessary as minors aren’t seen as legal persons under the law.
With this account, all trades are entered by the custodian on behalf of the minor (the beneficial owner).
The custodian manages all securities in a custodial account.
This happens until the minor is old enough to do so themselves at the age of majority, or an age determined by the state.
- Sell and buy securities
- Exercises warrants and rights
- Hold, trade, and liquidate securities
Property in the account can be used by the custodian in any way they feel they need to to support the minor.
This includes general use, overall support, paying for education, and more.
In most cases, expenses associated with raising a child – like shelter, clothing, or food – are not included.
There are some other rules regarding UGMA/UTMA custodial accounts that registered representatives should know:
- Transfers (in the case of UTMA) and gifts are considered irrevocable
- This account can only have one beneficial owner (minor) and one custodian
- A donor of securities may appoint a custodian or act as one themselves
- Parents have no legal control over these accounts unless they are the custodians thereof
- A custodian can be sued by the minor for improper actions
- Custodians can work with more than one account, as long as each account benefits one minor only.
- Minors can be the beneficiaries of more than one custodian account
- Custodian accounts may not be margin accounts, just cash accounts.
Transfer on Death (TOD)
A TOD account registration sees single or multiple beneficiaries receive a portion of an account, or perhaps all of it, upon the death of the owner of the account without the need for specific legal documents.
The owner of the account is allowed to change who the beneficiaries are as well as the percentages they are to receive at any point while they are still alive.
While estate tax on the account, if applicable, cannot be avoided, TODs do avoid probate.
While TOD account registrations are usually found on individual accounts, they could apply to some joint accounts, JTWROS for example.
They cannot apply to a TIC account, however.
Now that we’ve covered various individual and joint accounts, it’s time to move on to business accounts.
A sole proprietorship is treated much like an individual account and it’s the most basic form of business organization.
Much of the rules that would apply to an individual account are found here too, particularly when it comes to overall suitability.
With these accounts, the income achieved or losses made are for the individual that holds the account.
Also, there are risks involved.
That’s because the debts of the business are linked to the owner’s assets.
In other words, if things go bad, they could lose everything.
So that’s a major consideration when opening an account like this.
An unincorporated association of two or more individuals is known as a general partnership.
The operation and debts of the business are the responsibility of the partners that manage it.
While they might be easy to start and end, a partnership really isn’t a preferred way in which huge sums of capital can be raised.
When it comes to tax, the business’s profits and losses pass directly through the investors.
This means that at the individual and business level, the double taxation of profits won’t occur.
When looking at an investment policy for a general partnership and because losses and income flow through each partner, you have to take into account all partners’ collective objectives.
In a limited partnership, a general manager is assigned an enterprise’s management and liability.
The limited partners, however, only have liability limited to their investment and remain passive.
A great example of this is direct participation programs (DDPs).
As for suitability decisions, other than the fact that general partners have full liability and limited partners don’t, they should be similar to that of a general partnership.
LLC – Limited Liability Company
An LLC has some advantages as a business structure.
That’s because it offers the tax advantages of a partnership thanks to the flow-through of taxable earnings (losses).
But it also has the limited liability advantages of incorporation.
Owners of an LLC are not shareholders but members.
They cannot be personally held liable for any debts an LLC incurs.
As for suitability, when deciding on the merits of an LLC, the financial constraints and objectives of each member – much like in a partnership – must be taken into account.
An S corporation provides investors with the limited liability that corporations receive in general but it is taxed in a similar manner to a partnership.
Any profits and losses go directly to shareholders based on how many shares they own in an S corporation (a proportionate amount).
S corporations can only have up to 100 shareholders or more than one stock class.
For the most part, that would be common stock.
Also, none of these shareholders are allowed to be nonresident aliens.
Investment advisers need to see whether the owners of the S corporation meet suitability standards.
This is true for all organizations that don’t have liability and are not subject to tax.
Other than S corporations, this includes partnerships and LLCs.
This business structure separates a company from those who own it and it’s the perfect form for one that will need significant capital at some point.
When it comes to the corporation’s debts and losses, the directors and officers in a C corporation cannot be held personally liable.
Shareholders too are protected from any creditors.
As for corporate income tax, shareholders need not worry about that either as it only applies to the corporation and is not passed through to them.
C corporations do get double taxed on earnings, however.
First, they are taxed to the corporation before distribution, and secondly, when the dividend is paid out, they are taxed again to the shareholder.
When determining suitability for a C corporation, always consider its overall objectives and financial needs.
Following legal requirements when opening accounts
CIP – Customer Identification Program
Broker-dealers must institute a customer identification program (CIP) as required by the USA Patriot Act (2001).
This helps to:
- Provide a verification that the new customer is who they say they are. This can be achieved with a state ID, passport, driver’s license, or military ID. If the customer is not a person, but an entity this can be achieved with certified articles of incorporation or a government-issued business license.
- Keep records of the information obtained in the verification process (a copy of state ID or business license for example)
- Find out if the person is on the Office of Foreign Assets Control (OFAC) list for suspected terrorists or terrorist organizations. Certain countries and regions appear here too so entities or potential customers from these countries are a no-go area.
The following information must be obtained as part of the CIP:
- Customer name
- If an individual, their date of birth
- Address (either a residential address or post office box number or address of next of kin or other contact persons for an individual and a place of business address, postal address, or local office address for an entity)
- Tax ID number for a business entity or social security number for an individual
- Non-U.S. persons must supply at least two of the following: taxpayer ID number, passport number, and country issued, alien identification card number, or other country issued identification (with a photograph). If they have applied for a social security number but have yet to receive it, an exception can be made but the number must be obtained in a reasonable time period.
In some circumstances where the broker-dealer cannot come to a reasonable belief that it knows the customer’s true identity, the CIP must include certain procedures and they should describe:
- When an account should not be opened by a broker-dealer
- While the broker-dealers tries to verify a customer’s identity, what terms may they conduct transactions
- If attempts to verify a customer’s identity fail, when should a broker-dealer close the account
- When, according to applicable law and regulation, the broker-dealer should file a suspicious activity report
Other members’ employee accounts
There are special procedures and rules that govern the establishment of accounts for:
- Member firm employees
- Their spouses or minor children
FINRA requires that before placing an initial securities order or opening an account, the person associated with the member must notify both the employer and the executing member where the account is to be held, and of their association with the other member.
The employing FINRA member firm has to provide written permission before the account is opened.
Once that’s obtained they must be sent various documents on the opening of the account if they request it including:
- Account statements
- Copies of confirmations
- Other documents they may request
As is often the case with rules and regulations, however, there are some exceptions.
For example, this isn’t necessary if the employee will just be purchasing either variable annuities or mutual funds straight from the issuer.
If they are purchasing fixed annuities, term life insurance, or other non-securities products, the rule does not apply either.
Note that the Municipal Securities Rulemaking Board (MSRB) has a similar rule.
The difference, however, is that the documents must always be sent, not just when requested.
The only exception is if the employee is purchasing municipal fund securities (529 college savings plans).
Trusted contact person (Rules 2154 and 4512)
Earlier, we mentioned how a requirement centers around finding trusted contact information for specific adults.
Who would be considered one?
Well, that’s covered under FINRA Rule 2165 and it’s a natural person:
- Who is over the age of 65 or
- Over the age of 18 who the member reasonably believes to have a physical or mental impairment
This is also known by FINRA as the Senior Exploitation Rule.
When a specified adult opens an account, similar information is required such as we’ve already covered above.
In other words, members must do their best to get contact information and the name of a trusted contact person.
FINRA allows a temporary hold (of 15 days) to be placed on the account of a specified adult, particularly when it comes to the distribution of funds.
This can be used, for example, if they believe that the specified adult’s account has been used for financial exploitation.
Regulation SP (privacy notices)
Another regulation that must be complied with when opening an account is Regulation SP.
The SEC enforces this regulation as a way to protect customer information and their overall privacy, particularly nonpublic personal information.
This includes social security numbers, transaction history, account balances, and the information that can be collected through internet cookies on web browsers.
Whenever a new account is opened and every year after that firms must send a privacy notice with all their privacy policies to customers.
They should also be given an option to opt out if the firm provides nonpublic personal information to unaffiliated third parties.
This can be carried out electronically, or by providing them with a form with check-boxes and a prepaid return envelope, or a toll-free number to call, for example.
Finally, Regulation SP tasks the broker-dealer with ensuring their own systems, for example, their information technology structure, is sufficient to keep this customer information secure.
Note, that this regulation differentiates between a consumer and a customer.
- A consumer will purchase a financial product from the firm and probably have more contact thereafter (they are only given an initial privacy notice)
- A customer will have a continual relationship with the firm (they are given an initial and annual privacy notice)
POA – Power of attorney
Power of attorney is necessary for people who aren’t named on the account but will have authority to trade.
If that’s the case, the broker-dealer can give that person access to the account, but first, the customer must file written authorization.
Without that authorization, they cannot trade on the account, only the account owner can.
That authorization can be effected through the power of attorney (POA).
There are two types:
- Full power of attorney: With this, those individuals who are not the owners of the account are allowed to deposit and withdraw securities or cash as well as make investment decisions on behalf of the owner of the account.
- Limited power of attorney: With this, the designated individual doesn’t have full power over an account. They do have some control, however, and this will be specified by the owner of the account, usually in the limited power of attorney document itself.
Usually, a limited power of attorney won’t allow for the drawing of funds out of the account but it will also have some trading authorization, like the entering of buy and sell orders.
A limited power of attorney is also known as limited trading authorization.
Lastly, we have to mention durable power of attorney.
This can be applied to both full or limited accounts.
When they are made “durable”, in the case that the grantor is incapacitated, those designated persons with power of attorney still maintain the power of the account.
This is often used in cases when physical or mental causes may incapacitate the grantor, for example, the accounts of the elderly.
Should either party die, however, this durable power of attorney falls away.
Qualified v Non-qualified plans
In the world of securities, there are many terms that while similar, their meanings are very dissimilar.
In this section, where we talk about qualified vs non-qualified retirement plans, there are many definitions to get your head around.
So let’s start this section by looking at a few:
- Tax deferred: All this means is that income tax is postponed to a later date. For example, tax on the contributions in most retirement plans only happens at withdrawal.
- Qualified plan: These are 401 (k), 403 (b), and other employer-sponsored retirement plans governed by the Employee Retirement Income Security Act (ERISA – 1974). Earnings in the account expand and are tax-deferred until the point that they are withdrawn. Contributions to the account are made with pretax dollars.
- Qualified: This usually applies to a traditional IRA or a qualified plan. Earnings in the account expand and are tax-deferred until the point that they are withdrawn. Contributions to the account are made with pretax dollars.
- Nonqualified: A deferred compensation plan and other employer-sponsored plans are nonqualified. On occasions, the term applied to annuities bought outside of a retirement plan on an individual basis.
- Deductible contribution: Individual employee contributions, either to a 401 (k) or other qualified plans or to a traditional IRA, for example. Contributions are tax deductible and can be included in tax returns.
- Nondeductible contributions: Made with after-tax dollars, this is a contribution to a qualified plan or an IRA (both traditional or Roth). While there is no benefit from nondeductible contributions, the funds do grow tax-deferred.
Retirement plans sponsored by employers
Many investors have their main goal set on retirement.
They invest because they want to ensure that come retirement age, they have enough money to be able to enjoy their golden years and live comfortably.
To do this, they join corporate retirement plans, set up their own, or sometimes, opt for both.
Whichever one they choose in the United States, there are two types of retirement plans: qualified or nonqualified.
With a qualified plan, pretax contributions are allowed, while after-tax money funds nonqualified plans.
For the most part, no matter whether a plan is qualified or nonqualified, money will grow tax-deferred until the time it is needed.
Occasionally, qualified plans contributions limits are adjusted while the taxable distribution is never taxed as a capital gain but as ordinary income.
That is true of all retirement plans, no matter if they are qualified or nonqualified.
In a qualified plan, when an employer contributes all the funds, it is known as a noncontributory plan and a zero tax basis (cost) exists for employees.
The basis is zero too when an employee’s contribution was pretax as well.
So when funds are received at the time of distribution, they are fully taxable because everything above cost is taxed.
The rate used here is the employee’s ordinary income rate.
Nondiscrimination rules don’t apply to nonqualified plans which means they don’t need to abide by ERISA regulations.
So for the most part, these plans are used by a certain type of employee, and in this case, it’s typically executives.
Let’s look at two specific types of nonqualified plans.
With a deferred compensation plan, an agreement is reached between an employee and the company.
In it, the employee is in favor of a payout in retirement and defers receipt of their current income.
This type of plan assumes that at retirement age, the employee will be in a lower tax bracket.
Plans like this cannot be used for people like board members for administrative and planning purposes as they are not seen as employees.
Should the business fail, however, an employee covered by a plan like this has no automatic rights to any benefits and instead, become a general creditor to the firm.
That makes a deferred compensation plan a risky option.
Should they leave their job before their benefits are due at retirement, a covered employee might forfeit them too.
At retirement, the benefit payable to the employee is taxed as ordinary income.
Also, when the benefit is paid out, the employer is allowed a tax deduction as well.
With so many disadvantages in place, who benefits from a plan like this?
Well, as mentioned, it’s aimed at executives and others who are close to retirement and receive a large compensation for their position.
Another type of retirement plan is a payroll deduction plan.
Here, a specific amount is deducted from an employee’s paycheck by the employer and is then set aside in the type of retirement vehicle of the employer’s choice.
Money is always deducted after taxes with a plan like this.
Note that a 401(k) plan is not regarded as a payroll deduction plan and it’s something they like to try and catch you out with on the Series 7 exam.
It is seen as a qualified plan.
Also, for the exam, always presume that a payroll deduction plan is nonqualified.
When compared to nonqualified plans, a qualified one offers a range of different tax benefits including:
- Contributions by employers are seen as a deductible expense
- For the most part, contributions by employees are from pretax money
- The account and any growth or earnings it achieves is tax-deferred until the time of withdrawal
- Under ERISA, employees are offered certain protections
We look at qualified plans in far more detail later in this study guide.
Before we jump into IRAS, it’s critical to first note the Setting Every Community Up for Retirement Enhancement (SECURE) Act passed in 2019.
Well, it changed several retirement account rules and these should be noted for the exam.
- The former age restriction of 70.5 was dropped for individuals with earned income making traditional IRA contributions. Both Roth and traditional IRAs have no upper age limit.
- At 72, rather than 70.5, RMD will begin.
- Two new 10% penalty additional exceptions were added. Firstly, in the first year after a child is born, up to $5,000. Secondly, in the first year after an eligible person is adopted, up to $5,000. If married, both spouses are allowed to withdraw $5,000 in both of these cases.
- Inherited retirement accounts must now be distributed by at least 10 years after the original owner’s death.
- Amounts paid as principal or interest on qualified education loans for the beneficiary and any sibling is now a qualified expense up to a maximum of $10,000 per child as per Rule 529.
- 401(k) plans are now eligible for ERISA for employees working 500 hours per annum for a three-year period. This allows coverage for part-time employees. This does not apply to 403(b) or 457 plans, however.
So now, let’s talk about IRAs.
As a way to encourage people to save for their future, IRAs were created.
It’s available for anyone that earns an income.
There are two types, each with its own contribution, tax, and distribution options.
These are traditional IRAs and Roth IRAs.
When IRAs started, this was the first type available.
The maximum allowed tax-deductible contributions for a traditional IRA are:
- The lesser of $6,000 per individual or
- $12,000 per couple
IRAs are tax-deferred up until the point that funds are withdrawn from them.
When it comes to compensation, the IRS allows for the following:
- Nontaxable combat pay
- Income generated by self-employment
- Bonuses and commissions
- Tips, salaries, and wages
The following is not considered to be compensation by the IRS:
- Capital gains
- Dividend and interest income
- Annuity or pension income
- Child support
- DDPs passive income
In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) allowed additional contributions to both traditional and Roth IRAs for certain individuals.
For example, catch-up contributions were allowed for those 50 and older and these could be above the scheduled maximum annual contribution limit.
The catch-up amount is currently $1,000.
A traditional IRA allows anyone of any age that earns an income during a given year to contribute towards it.
Spousal IRAs could be opened for a spouse who earns no or very little income and who together with their spouse, submit a joint tax return.
As with other IRAs, the tax treatment and contribution limits operate in exactly the same way.
Let’s now talk about earning limitations on tax benefits.
We’ve already mentioned earlier that with traditional IRAs, contributions can be deducted by participants from their taxable income.
Should an individual be covered by an employer-sponsor qualified plan, those deduction limits are reduced and in some cases totally eliminated.
AGI or adjusted gross income limits increase each year as well.
Income level is not a factor for individuals who are not part of qualified plans and they may deduct IRA contributions.
Specific taxable year IRA contributions can be made from 1 January right through to the filing date of that year’s return.
This is generally April 15 of the next year.
This is true even if the individual has obtained a file extension (which is a question that often appears on the exam).
Extensions never give more time to pay your taxes, only to file your return.
A 6% penalty tax is added should the annual IRA contributions exceed the maximum allowed.
This can be avoided if these are removed by no later than April 15 when the tax return is filed.
What’s different with them?
Well, they are still pretty new, having been created under 1997’s Taxpayer Relief Act.
While they are very similar to traditional IRAs as highlighted above, there are some differences.
That’s what we will focus on.
Taxation of contributions and withdrawals is the significant area where these two types of IRAs differ.
While contributions to traditional IRAs are tax-deductible, with a Roth IRA, this is not the case.
There is a change when it comes to earnings too.
These can be tax-free in fact, not only tax-deferred.
Five years following a deposit, the accumulated earnings can be withdrawn without having to pay tax if:
- The holder of the account is older than 59.5.
- The money to be withdrawn – up to $10,000 – will be used on the first-time purchase of a principal residence
- The account holder has become disabled or died
Because regular contributions are made with nondeductible contributions, they too may be withdrawn without any tax implications.
Roth IRAs share much of the same contribution limits as traditional IRAs but there is an important difference.
As long as the taxpayer has earned income, there are age limitations.
That’s no different from a traditional IRA.
If an individual wants to contribute to a Roth and a traditional IRA, they can.
It’s critical to note, however, that the maximum combined contribution can only be $6,000.
This goes up to $7,000 for those older than 50.
There are differences in eligibility requirements as well.
This is based on income.
That means that a person’s AGI must be below specified income levels to open a Roth IRA.
Before we get to them, let’s just have a look at what AGI actually is.
It stands for Adjusted Gross Income (AGI).
It’s a calculation that individuals make and is filled in on a Form 1040.
When completing tax returns, individuals should list all income earned which includes their salary, wages as well as any bonuses they may have been paid.
To this, income interest, dividends, capital gains, business profits and alimony received must be added.
Then a range of items is taken off that amount to get to your AGI.
These deductible items include:
- Traditional IRA contributions
- Alimony paid
- Self-employment tax
- Early withdrawal penalties relating to a savings account
The 2019 levels were as follows:
- Those individuals with $123,000 or less AGI are allowed to contribute the full amount
- As the AGI rises to between $123,000 and $137,000, contributions are phased out gradually
- For those who file joint tax returns, AGI is limited to $193,000 while contributions are phased out between $193,000 and $203,000.
A traditional IRA can be converted to a Roth IRA but there are income tax consequences that need to be taken into account.
The amount converted will be put with the ordinary income of the investor.
There isn’t a distribution tax penalty for those under the age of 59.5 as long as a certain condition is met.
The funds must be done trustee to trustee in a direct rollover or, if they are distributed to the owner, they must be rolled over in 60 days.
A proportionate system is used to determine how much of the contribution is taxable if only a portion was made with after-tax money.
Note that qualified employer plans such as 401(k) and 403(b) allow for conversions too.
Let’s recap on some key points that you should remember about Roth IRAs.
- Any contributions made won’t be tax deductible
- If the Roth account has been opened for five years, distributions for someone over the age of 59.5 are tax-free
- As long as there is an earned income, contributions can be made at any age
- It’s not a requirement that distributions start at the age of 72
- A distribution is qualified and won’t be subject to a 10% penalty or tax if because of disability, death, or a first-time home purchase
- Beneficiaries of Roth IRAs can include minors
- All after-tax money contributions are allowed to be withdrawn without penalty or tax implications.
Traditional IRA withdrawals
We’ve looked at contributions to both traditional and Roth IRAs but what about withdrawals?
For a traditional IRA, you are allowed to draw from them without a penalty as long as you are older than 59.5.
Also, the year an individual turns 72, distributions must start by April 1 of the year following that.
Should a distribution occur before the age of 59.5, they will be subject to tax penalties.
Penalties could also apply if withdrawals less than the required minimum distributions (RMD) are made after the age of 72.
Withdrawals are taxable as ordinary income.
A formula is used in the situation if they are both deductible and nondeductible contributions,
In it, a part of the withdrawal constitutes a nontaxable return of principal.
10% early withdrawal penalties apply to taxable withdrawals before the age of 59.5 unless:
- The withdrawal is made because of a death
- The withdrawal is made because of a disability
- The withdrawal is made for a first time primary residence purchase ($10,000 lifetime maximum)
- The withdrawal is made for qualified higher education expenses (for immediate family including children and grandchildren)
- The withdrawal is made to cover medical expenses that are higher than an AGI limit
We know that withdrawals must begin the year following after the account owner reaches the age of 72.
They also must start by April 1.
Withdrawals will incur a 50% penalty on the amount short of the RMD should they not meet minimum Internal Revenue Code (IRC) distribution requirements.
With a Roth IRA, the age of 72 is irrelevant, however.
Roth IRAs can grow tax-free until the point the holder decides to withdraw from them and no RMDs apply to them either.
Should someone want to withdraw from their IRA before the age of 59.5 without penalty, there is a way in which it can be done.
This falls under IRS Rule 72 (t) and is known as a substantially equal periodic payment exception.
Here, a 10% penalty does not apply if the person receives payments from their IRA at least each year based on their life expectancy or joint life expectancy (if including beneficiaries).
To determine the payment at certain ages, use the IRS tables that help determine them.
It’s critical to note that beginning distributions can be postponed:
- The year after you turn 72 but by April 1
- The year after your retirement year but by April 1 (not for an IRA but only for qualified plans)
Nondeductible capital withdrawals
When withdrawn from an account, funds are not taxed if they were contributed as after-tax dollars.
Funds resulting from investment gains or income, however, will be taxed at the ordinary income tax rate when they are withdrawn at some point in the future.
The IRS also has a formula that helps determine how much money can be withdrawn if the client is in the middle of the phaseout range which means portions of the contribution are pretax and therefore deductible and the rest of it, post-tax.
When you face questions in the Series 7 exam about IRAs, always assume that they are traditional and not Roth unless the question says differently.
IRA funds can be used in numerous ways, including buying various securities including bonds, stocks, mutual funds, UITS, REITs, government securities, annuities, U.S. Treasury coins, and more.
Note that these investments should always reflect the age and risk tolerance of the investor.
They should also always be relatively conservative.
The ultimate aim here is long-term growth, particularly as the IRA is going to be a source of retirement funds for an individual.
Inappropriate and ineligible investments
IRA investments that are not acceptable include:
- Collectibles (stamps, rare coins, etc)
You may not purchase whole life or term life insurance contracts with an IRA either.
So what can you purchase using an IRA?
Well, any of the following:
- Tax-free municipal bonds
- Municipal bond funds
- Municipal bond UITs
It’s important to note that while these might be eligible, they are considered to be appropriate for any tax-qualified plans or IRAs thanks to the fact that their yield is lower than other investment choices that are similar.
Also, there are tax implications when the income generated is withdrawn from the IRA.
Ineligible investment practices
With any retirement plan, including IRAs, there cannot be sales of speculative options strategies, margin account trading, or short sales of stock allowed.
Covered call writing is, however.
Method’s for moving IRAs
There are three ways in which an IRA can be moved from one to another.
- Trustee to trustee offer
- Direct rollover
- 60-day rollover
Let’s start with the 60-day rollover, often called an IRA rollover.
Here, in order to move a retirement account from one custodian to another, the IRA account owner is allowed to take temporary possession of the funds in the account.
This, however, is only allowed once every 12-month period.
As for the period that the rollover must be completed in, well that’s 60 calendar days from the original date on which the funds were removed from the original fund.
If the account owner doesn’t want to be subjected to an early withdrawal penalty or have the unrolled balance subject to income tax, 100% of the funds should be deposited in the new account.
Also, 20% of the distribution must be held by the payor as withholding for tax.
But what about from an employer-sponsored retirement plan to an IRA?
Well, this is known as a direct rollover and can be carried out on a traditional or Roth IRA.
Generally, this happens when you either retire from a company or terminate your employment.
In some cases, there could be a direct rollover in the retirement plan of your new employer.
If that’s not the case, however, you can simply roll over the money into an IRA.
Whichever option is chosen, the money never comes to the person at all, but goes straight from one plan to the next.
Lastly, we need to cover trustee to trustee transfers.
This sees account assets move from one custodian of an IRA directly to another with the account owner never given the funds to move them across themselves.
It’s also known as an IRA transfer and the difference between this and a typical IRA rollover is that it can be carried out unlimited times, not just once every 12-months.
Also, the 20% federal tax withholding is not applicable here either.
With no specific time limit, there is no need to worry about a 60-day requirement as with a typical IRA rollover.
Education IRAs were brought into existence as part of the Taxpayer Relief Act (1997) with an annual contribution limit of $500.
They aren’t often called education IRAs as their name was changed in 2002 to Coverdell ESAs and the annual contribution limit quadrupled to $2,000.
These after-tax contributions can only be made in cash and before the beneficiary reaches the age of 18.
Provision is made for special needs beneficiaries and they can be given an extension over the age of 18 to complete their education.
By allowing after-tax non-deductible contributions which accumulate on a tax-deferred basis, Coverdell ESAs can be used to help fund education expenses.
The earning portion of the distribution will be excluded from income as long as it pays for education expenses that are qualified when Coverdell ESA distributions are made.
Should they not be used for education expenses, the withdrawal amount will receive a 10% tax penalty.
All withdrawals are taxed to the recipient.
Not only can this account type be used for qualified higher education but for elementary and secondary school as well as for private, public, or religious schools.
Note that depending on filing status and the amount of AGI, contributions to a Coverdell ESA may be limited.
Other ESA features include:
- Contributions can continue past the age of 18 for special needs beneficiaries
- Like an IRA any year’s contributions can be continued until April 15 of the following year
ESA key points include:
- Parents and other adults can contribute to ESAs but the total for one child is $2,000 until their 18th birthday
- While earnings are tax-deferred, contributions are not tax deductible
- If used for eligible education expenses, distributions are tax-free if used before the age of 30
- Should funds in an ESA not be used by the age of 30, they are distributed and will incur a 10% penalty while subjected to income tax. They can be rolled over into another ESA for a different family member.
Employer-sponsored retirement plans
There are a few different employer-sponsored retirement plans that you should know about.
Tax-sheltered annuities (403(b) plans)
Tax-sheltered annuities (TSAs) are available to:
- Employees of public educational institutions
- Employees of tax-exempt organizations (for example, nonprofit (501 (c)(3) organizations)
- Employees of religious organizations
As long as they do not exceed limits, qualified employees can exclude contributions from their taxable income.
TSAs are meant to be used as a way to save towards retirement offered under Section 403 (b).
With this in mind, there are tax penalties if savings are taken out before the employee reaches the age of 59.5.
Should an employee be older than 21 and have at least one year of service at their place of employment, they can sign up for a TSA.
It’s particularly popular at charitable institutions, schools, colleges, universities, private hospitals, museums, and more.
Elective employee deferrals are the means through which TSAs are funded.
Earnings increase in a tax-free manner until the time of distribution as the deferred amount is not included in the gross income of an employee.
The employer and employee must carry out a written salary reduction.
Also, contributions to the 403(b) can be made solely on behalf of the covered employee by the employer or together with an employee deferral.
Similar to other plans, a 10% penalty will be applied for early withdrawals before the age of 59.5.
Distributions are also 100% taxable.
No, students at an educational institution cannot participate in a TSA, it’s only for employees.
This is a question that comes up from time to time on the exam.
Now that we know more about it, what type of tax advantages does a TSA offer?
Well, two stand out:
- A participant’s gross income isn’t affected by contributions because they are excluded from it. This means that ultimately, they don’t suffer a reduction in salary from a 403 (b) plan.
- Earnings for participants amass tax-free until it’s time for distribution
From 1974, mutual funds could be purchased as part of these plans.
Estimates suggest, however, that around 8% of all these plans see their money up into either fixed or variable annuities.
Section 457 plans
Set up under Section 457 or the tax code, a section 457 (b) is a deferred compensation plan.
It’s mostly used by those employed by the state in various capacities, including any agencies or political subdivisions.
But it’s not only those organizations that make use of Section 457 plans.
It’s also for other organizations that are exempt from tax.
These include unions, charities, and hospitals as an example.
Compensation can be deferred by employees in a 457 plan even though technically, it is a nonqualified plan.
The chosen amount that is deferred doesn’t have to be reported for tax purposes either.
This means that for the amount deferred an employee will receive a deduction each year.
Several critical facts are important to know about 457 plans
- They are ERISA exempt
- Unlike other retirement plans, a 457 plan doesn’t have to follow nondiscrimination rules
- In a tax-exempt business or organization, plans can only cover those employees that are highly compensated. For a government entity, any employee and even independent contractors can take part in the plan
- A rollover into an IRA cannot happen to distributions for nongovernmental tax-exempt employees who hold 457 plans. Early withdrawal, however, does not suffer from a 10% penalty.
- 457 plans can be held in conjunction with other plans such as a 401 (k), 403 (b), and even an IRA with employees making maximum contributions to both.
Corporate-sponsored retirement plans
Let’s look at those retirement plans sponsored by corporations.
There are numerous types including:
- Pension plans
- 401 (k) plans
- Profit-sharing plans
The establishment and management of corporate pension plans or private sector plans as they are known are regulated under the ERISA act of 1974.
A trust agreement is how all qualified corporate plans are established.
With this trust agreement, all plans will have a trustee appointed.
They have fiduciary responsibility.
This means they should always act in the best interest of the plan holders as well as the plan itself.
Let’s look at two specific types of corporate-sponsored retirement plans.
Those are defined contributions and defined benefit plans.
- Defined contribution plans: These focus on current, tax-deductible contributions and don’t provide a specific end result
- Defined benefit plans: These do not specify a level of current contributions but do promise a defined retirement benefit
Defined contribution plans
These can include 401 (k), profit-sharing, and money purchase pension plans.
When compared to an IRA, the contribution an employer makes to these kinds of plans is far higher.
These funds will accumulate until they need to be withdrawn, which is usually at retirement.
The value of that withdrawal is depending on several factors including contributions made as well as the capital and interest gained as a result of the investment.
While there is investment risk, it’s generally pretty minimal but that risk falls on the plan participants’ shoulders.
Defined benefit plans
Here, the idea is a defined benefit at retirement that will be provided to plan participants.
An example of that is a fixed monthly income.
This benefit will be drawn up in the contract terms of the plan and cannot be influenced in any way, not even by investment performance.
In terms of risk, well that’s assumed by the benefit plan sponsor and not the participants.
How is the benefit calculated for each individual?
Well, by taking into account the two key factors: years of service and the last five years before retirement’s average salary.
These plans have dropped in popularity over the years.
That’s because they aren’t only complex but also can be expensive from an administrative point of view (for example, only an actuary can sign the plan’s annual return).
In 1979, around 28% of workers had this type of plan.
40 years later, that’s dropped to just 4%.
Let’s also talk about the difference between contributory and noncontributory plans.
With the first, it’s both the employer and employee that contribute to the plan.
The most common of these is a 401 (k) plan.
In this, the employee can decide how much they want to contribute which is then matched by the employer.
In a noncontributory plan, it’s only the employer that makes the contributions.
Note that it’s mandatory for an employer to contribute to a defined contribution or defined benefit plan and those contributions are 100% deductible for the company.
That’s not the case with profit-sharing or 401 (k) plans.
With a profit-sharing plan, an employee may participate in the profits a business makes and a predetermined contribution formula, as found in other plans, isn’t necessary.
If they do use a formula, however, then contributions are profit fixed percentages.
According to the IRC, these plans need recurring, substantial contributions to qualify.
Because of their contribution flexibility for employers, profit-sharing plans have become highly favored, especially to those companies where cash flow is unpredictable.
That’s because, during times where profit margins are low, they can actually skip contributions and make it up later.
Their popularity also stems from the fact that profit-sharing plans are easy to administer.
401 (k) plans
We’ve mentioned 401 (k) plans numerous times already but let’s get a little more in-depth and see what they have to offer.
Here, the employer will deduct a percentage from the salary of an employee under their instruction and decided by them.
Employers contribute the same amount with both amounts (which are pretax) placed in a retirement account.
This means that a 401 (k) plan is considered a defined contribution plan.
Roth 401 (k) plans
You’ll find that on existing 401 (k) plans, a Roth option might be made available.
What this means is that the option brings both the features of a 401 (k) plan and a Roth IRA and combines them.
They allow for tax-free withdrawals but also have after-tax contributions as you’d find with a Roth IRA.
For a tax-free withdrawal, the retiree must be 59.5 or older and their Roth 401 (k) plan must at least be five years or older.
Note, that employer contribution is placed in a regular 401 (k) account.
Upon withdrawal, that amount will be taxed.
Interestingly, with two accounts, a 401 (k) and a Roth 401 (k), an employee can contribute to either account.
If they have contributed to both at some point, money cannot be transferred between the two accounts.
A Roth 401 (k) differs from a Roth IRA in the fact that it doesn’t have an income limit restriction.
Therefore anyone may participate in one.
Note while Roth IRAs don’t require withdrawals by no later than the age of 72, a Roth 401 (k) will as per rules applied to all RMDs.
Other corporate plans
Here are a few other corporate-sponsored plans which can appear on the Series 7 exam from time to time.
Simplified Employee Pension (SEP-IRA).
This easy-to-administer plan is aimed at small businesses or those who are self-employed and function as a qualified individual retirement plan.
SEP IRAs are set up by employees and employers are then able to contribute towards them.
IRS rules state that an eligible employee must:
- Be 21 years of age or older
- Have worked for their employer in three of the last five years
- Have received $600 or over from their employee in the last year
If a person is self-employed they may contribute to a SEP IRA for themselves as well as anyone they employ but they cannot make catch-up contributions.
An employee, however, can but there are provisos.
First, the SEP must allow it and secondly, the employee must be over the age of 50.
Lastly, the contributions made by an employer to the SEP account on behalf of the employee can be excluded from their gross income.
Also, contributions made by an employer are tax-deductible.
Savings Incentive Match Plans for Employees (SIMPLEs).
This is aimed at a business that employs 100 or fewer people.
During the preceding calendar year, these employees should have earned $5,000 and no other form of retirement plan can be active for them if a SIMPLE arrangement is to be set up.
How does it work?
Well, pretax contributions up to an annual contribution limit are made by employees in the plan.
The employee will then match those contributions with limits for employers and matching contributions requirements set out by the IRS.
Catch-up contributions are possible for employees over the age of 50 and can amount to $3,000.
What about a plan for a self-employed person that runs their own business without any employees?
Originally, these were called H.R. 10 plans but that’s a term that isn’t used often, although you might see it on your exam.
These plans are pretty straightforward and provide a way for a business owner to save for his retirement.
Stock purchase plans and stock options
In some publicly traded companies, employees have the opportunity to purchase stock.
The most common way for this to happen is through an employee stock purchase program (ESPP).
With plans like this, the operations side of things allows employers to purchase stock as a type of payroll deduction plan essentially.
Money taken from the employees’ paycheck (after-tax) is put into an escrow account.
Then, on a periodic basis, usually every six months, this money is used to buy company shares.
While they do not have formal stock option arrangements, plans like this are similar to other stock option plans as they provide employees with ownership of the company through the shares they buy.
Here are some critical mechanics behind an ESPP.
- Contributions towards purchasing stock can be between 1% and 10% of an employee’s salary. While calculated on a pretax salary, the contribution is taken after tax.
- Contributions are used at the end of the purchase period to buy company stock for participants. Whichever is lower between the company stock price at the start of the purchase period and at the end, the price that will be paid for the stocks, usually along with a discount.
- The stock can be sold by participants if they wish but if they hold onto it, they will receive preferential tax treatment.
Instead of a purchase plan such as ESSP, an employer might offer stock options instead.
With this, common stock can be purchased for a predetermined price and for a period of time as set out by the employer.
Only those employees of the issuing company may purchase stock options like this although a plan like this must be approved by the board first before it’s allowed.
Also, a vesting period for the stock will state a minimum time employees have to stay with the company in order to use the option.
ERISA – Employee retirement income security act (1974)
As a way to ensure that employee pension funds are not abused or misused, ERISA was promulgated in 1974.
Guidelines from ERISA are for all corporate retirement plans as well as some union plans too.
It does not apply to the public sector or nonqualified plans at all.
- Participation: Essentially, this covers employee eligibility rules. If they are over 21, been with the company for one year (or 1,000 hours), employees must be covered.
- Funding: Other corporate assets and the funds contributed to the plan must be segregated at all times. Contributions limits to the IRS must always be observed and the assets must always be invested with the participants’ best interests in mind.
- Vesting: How long the vesting schedule runs is limited by ERISA but they are always fully vested to their own contributions.
- Communication: Annual statements and updates of plan benefits must be made available to employees. All other documents relating to the plan must be in writing too.
- Nondiscrimination: A uniformly applied formula for the plan will ensure that all eligible employees are treated impartially.
- Beneficiaries: All employees must name beneficiaries to receive their benefits should they die.