General Financial Principles, Professional Conduct, and Regulation
The Watsons are recently retired and are ready to take a European vacation to celebrate their 40th wedding anniversary. When they return, they would like to meet with their financial planner to discuss setting up a family foundation to continue their lifelong philanthropic endeavors. The Watsons are currently in which life cycle phase?
Distribution phase
The distribution/gifting phase begins subtly when a couple realizes they can afford to spend on things they never believed possible. The asset accumulation and conservation/protection phases make this phase possible. For many people, there is a period when they are being influenced by all three phases simultaneously, although not necessarily to the same degree.
Steve purchased a house for $750,000. The house has a replacement cost of $1 million with an 80% coinsurance provision and a $2,000 deductible. What is the minimum amount of coverage Steve should have on the house in order to be fully covered for a partial loss up to the policy limit?
$800,000
Under the coinsurance provision, the amount of coverage required to fully cover a partial loss up to the policy limit would be $800,000, or 80% of $1 million. Financial planners should always recommend that homes be insured for 100% of replacement cost in order to protect against a total loss. Homeowners insurance policies only cover damages up to the policy limit.
John's portfolio has $15,000 invested in Security A, $30,000 invested in Security B, and $45,000 invested in Security C. If Securities A, B, and C have betas of 1.5, 1.2, and 0.9, respectively, what is the weighted beta of John's portfolio?
1.10
| Security | FMV | Beta | Product |
| A | $15,000 | 1.5 | $22,500 |
| B | $30,000 | 1.2 | $36,000 |
| C | $45,000 | 0.9 | $40,500 |
| $90,000 | $99,000 |
The weighted beta for this portfolio is 1.10 ($99,000 ÷ $90,000).
Cathy sold 100 shares of GlassCo stock for $5,200. She paid $4,000 for the stock 2 years ago. Commissions of $80 on the sale and $50 on the purchase were paid. What is the amount realized and the gain recognized, respectively, on this sale?
| Amount realized | Gain recognized |
| $5,120 | $1,070 |
The amount realized is the sales price less the commissions paid on the sale ($5,200 − $80 = $5,120). Her basis in the stock is the purchase price of the stock plus commissions paid at purchase ($4,000 + $50 = $4,050). Therefore, the amount realized is reduced by Cathy's basis in arriving at the taxable gain of $1,070 ($5,120 − $4,050).
On January 15, Derek, age 40, withdrew $50,000 from his traditional IRA. The balance in the IRA was $500,000 before the distribution. Derek made contributions to the IRA of $30,000 over the last 18 years, of which $10,000 were deductible. What is the amount of any early distribution penalty?
$4,800
Before determining the early withdrawal penalty, the taxable portion of the distribution must be determined. Derek made $20,000 of after-tax contributions to the traditional IRA, calculated as follows:
| Total contributions to IRA | $30,000 |
| Deductible contributions | − 10,000 |
| After-tax contributions (basis) | $20,000 |
After-tax contributions into a traditional IRA are recovered pro rata when a distribution occurs. Because Derek distributed 10% of his IRA balance ($50,000 distribution divided by $500,000), 10% of the basis is recovered.
| Distribution from IRA | $50,000 |
| Basis recovery ($20,000 × 10%) | − 2,000 |
| Taxable portion of distribution | $48,000 |
The early withdrawal penalty is $4,800 ($48,000 × 10%).
Two years ago, Samantha and Troy hired Mr. Williams, a CFP® professional, to manage their money. The couple started to worry about their asset management account when they noticed the account had lost about 25% of its value while the market as a whole had only lost 7%. After contacting another advisor, they discovered that Mr. Williams was not actively managing their account as stated in both the investment advisory agreement and Form ADV Part 2A. Instead, Mr. Williams simply purchased securities at the relationship onset and did not bother to rebalance or contact the couple regarding their losses. Based on the information provided, which of the following best describes Mr. Williams' actions with regards to the couple?
Criminal mischief
Civil malfeasance
Violation of fiduciary responsibility
Breach of contract
Breach of contract
If a financial planner has agreed to perform certain services for a client and fails to honestly, properly, and completely perform those contractual duties, the financial planner will be civilly liable to the client for breach of contract.
Which of the following is(are) characteristics of a personal liability umbrella policy (PLUP)?
1, 2, and 4
Coverage under a PLUP is inexpensive.
Jasmine has a large paper profit in her Amalgamated Corporation shares, which are currently trading at $42 per share. She does not mind holding on to the stock and understands that positive price movements may not last forever. If she is willing to sell the shares at $50, what is the best strategy for her to implement?
Sell $50 call options
Buy $50 put options
Place a limit order at $50
Place a stop order at $38
Sell $50 call options
Selling a call option will allow Jasmine to generate income from the option premium with little risk, because she does not expect the stock to continue to increase in price. If the stock does exceed $50, she would be paid what she wants for the stock. The limit order will neither provide any income nor guarantee fulfillment if the stock price stays below $50. The stop order may help Jasmine in case of the stock falling in price. However, this order will change to a market order when the price reaches $38 and may be filled at a different price.
Hank sold several Section 1231 business properties during the current year. His overall gain was $34,000, his depreciation recapture was $15,000, and he held all of these properties for more than 1 year. The only other Section 1231 transactions Hank has had were in the last 3 years. He had a net gain of $7,500 3 years ago and a net loss of $9,000 2 years ago. He had no Section 1231 transactions last year. How are Hank's gains for the current year treated on his income tax return?
| Ordinary gain | LTCG |
| $24,000 | $10,000 |
The overall gain to be recognized is $34,000. Section 1231 gain is typically taxed as a capital gain. However, depreciation recapture will convert some or all of the capital gain to ordinary income in the year of sale. In addition, the look-back rule requires a taxpayer to look back for any unrecaptured Section 1231 losses. These unrecaptured losses also will cause some or all of the current-year Section 1231 gain to be treated as ordinary income. The capital gain in the current year is determined as follows:
The remaining gain of $24,000 ($34,000 less $10,000 capital gain) will be taxed as ordinary income.
| Total gain - current year | $34,000 |
| Less current year depreciation recapture | (15,000) |
| Less unrecaptured losses in past 5 years | (9,000) |
| Equals capital gain | $10,000 |
Mrs. Snodgrass taught for 32 years in a school district that opted out of Social Security. However, during the summers she taught karate for a business for 12 years. Her Social Security estimates always said she would receive $1,000/month in her retirement. Now she filed for Social Security at her full retirement age, but her first check is only $600/month. She is still teaching school and she hasn't signed up for Medicare. She comes to her first appointment with you and asks what is wrong with her Social Security check. Mr. Snodgrass has not worked much due to a disability that started when he was 26. His Social Security is $700/month before taking out Medicare Part B. How should you respond?
Social Security is a government program so it makes a lot of mistakes. This is probably their fault and it should be corrected over time.
She may be experiencing the effects of the Government Pension Offset.
She may be experiencing the effects of the Windfall Elimination Provision.
They are probably withholding money for her income taxes. She will benefit from that when she files her income taxes.
She may be experiencing the effects of the Windfall Elimination Provision.
Mrs. Snodgrass is fully insured so her Social Security retirement benefit should be 100% of her PIA ($1,000/month). However, her history with an employer outside of the Social Security system subjects her to two additional Social Security benefit rules. The Government Pension Offset reduces Social Security spousal retirement benefits. But she is still teaching and thus has not started receiving her teacher retirement, so her spousal benefits at her FRA would be $350/month (half of his) until she did start receiving teacher retirement benefits. Since she is getting $600/month this isn't the problem. The second Social Security benefit adjustment is the Windfall Elimination Provision. It reduces Mrs. Snodgrass' retirement benefit received from her own work history. The maximum reduction is about $450/month. This is probably the issue. Remember, the "W" in Windfall stands for "worker." The Windfall Elimination Provision reduces the Social Security retirement benefits based on the worker's own situation. The Government Pension Offset reduces the spousal benefits from their spouse's earnings under Social Security.
Michael and Kate visit with Bob, a CFP® professional, to review their existing financial plan. Bob recommends that the couple transfer Michael's traditional IRA to another traditional IRA even though his existing IRA is adequate. If the couple decides to move forward with Bob's recommendation, they will be subject to commissions and other fees by closing the existing IRA. Furthermore, Bob improperly completed the beneficiary designation on the new IRA by making the couple's children primary beneficiary and Kate secondary beneficiary. To whom is Bob liable for his errors?
Both statements I and II are correct.
Financial planners who fail to perform these duties may be civilly liable to their clients, for whom they have agreed to provide services, and to third persons, who may have relied on statements prepared by them.
Rilee Corporation purchased a $50,000 whole life policy on a key employee, Susan. When Susan terminated employment with the corporation her husband, Ryan purchased the policy from the corporation for $15,000. Ryan designated himself sole beneficiary and had paid premiums of $8,000 by the time his wife died. What are the tax consequences to Ryan upon receipt of the life insurance proceeds?
Ryan would receive $23,000 tax free and $27,000 as ordinary income.
Because Ryan's purchase of the policy falls under the transfer-for-value rule, the death benefit is included in Ryan's gross income to the extent it exceeds his basis in the contract. Ryan has a basis of $23,000, which represents the $15,000 he paid for the policy plus the additional $8,000 he paid after purchase.
Billy, a portfolio analyst, has compiled the following information.
| 10-year average return | σp | ßp | |
| Portfolio A | 5.75% | 8.6% | 1.06 |
| Portfolio B | 8.59% | 20% | 2.05 |
| Portfolio C | 9.84% | 12.5% | 1.43 |
The risk-free rate of return is 1.15%. Rank these portfolios from best to worst risk-adjusted performance.
C, A, B
Sharpe is the preferred measure of risk-adjusted performance because this ratio encapsulates total risk by using standard deviation in the calculation.
Portfolio A: (0.0575 − 0.0115) ÷ 0.086 = 0.5349
Portfolio B: (0.0859 − 0.0115) ÷ 0.20 = 0.3720
Portfolio C: (0.0984 − 0.0115) ÷ 0.125 = 0.6952
Jim, recently retired, is 62 years old and expects to be in the maximum federal and state tax bracket. He plans to liquidate three of the investments listed below. Assume that each investment is worth $50,000 and has grown from an original investment of $25,000 over a period of more than 3 years. Liquidation of which three of the following investments, in order of priority, would result in the lowest tax liability for Jim? (CFP® Certification Examination, released 08/04)
2, 5, 3
The CD, blue-chip stock, and savings bonds (in that order) would result in the lowest tax liability upon liquidation. Because the interest on the CD was taxable each year, the basis in the CD would be equal to the value. Therefore, no federal or state income taxes would result upon liquidation. The appreciation of the blue-chip stock would be taxed, but at favorable capital gains rates. For U.S. savings bonds, the appreciation would be taxed at ordinary income tax rates for federal income tax purposes. However, savings bonds are not subject to state income taxes. For the traditional IRA, the appreciation only (client has basis for the contributions because they were nondeductible) would be taxed at both federal and state ordinary income tax rates. For the 401(k) plan, the entire amount would be taxed at both federal and state ordinary income tax rates.
Note: In the online version of Kaplan Schweser's QBank, the letters preceding the answer choices that appear in the original CFP Board question have been eliminated. The answer choices may not be in the same order as in the original CFP Board released questions.
Arnold is age 65, in good health, and single. He owns assets valued at over $20 million, including an insurance policy on his own life with a death benefit of $1 million and a current replacement cost of $350,000. He also owns a parcel of vacant land currently valued at $1 million, which he does not expect to appreciate in value over the next few years, and a savings account with a current balance of $1 million. He is thinking of making a gift to his niece, Betty, but he wants to do so in the way that will be most beneficial in reducing his federal estate tax when he dies. Which of the following recommendations is most suitable for meeting Arnold's objectives?
Gift the life insurance policy directly to Betty
Gift the vacant land to a revocable living trust with Betty as the remainder beneficiary
Gift the $1 million bank account directly to Betty
Gift the vacant land directly to Betty
Gift the life insurance policy directly to Betty
The most suitable recommendation is to gift the life insurance policy directly to Betty. If Arnold survives for more than 3 years after making the gift, the $1 million death proceeds will be excluded from his gross estate. The current replacement cost of $350,000 (minus the gift tax annual exclusion amount, if available) will be added to the taxable estate as an adjusted taxable gift (ATG). Gifting the bank account or vacant land directly to Betty is less helpful because in either case, the current value of $1 million (less the gift tax annual exclusion amount, if available) will be added to the taxable estate as an ATG. If Arnold gifts the land to a revocable living trust, the FMV of the land on Arnold's date of death (or alternate valuation date, if elected) will be included in Arnold's gross estate.
Bob is a fisherman with the local fish market. He and his wife Mary want to retire in 20 years. They expect to live approximately 25 years after retirement and need $40,000 (in today's dollars) annually during retirement. Unfortunately, they have just spent their savings on refurbishing their boathouse and have only $12,000 in retirement savings. Inflation is currently 2% and is expected to continue indefinitely. Bob believes he can earn an 8% rate of return before retirement but expects to earn only 6% during retirement because of the change in his portfolio's asset allocation at retirement. How much does Bob need to save at the end of each year to meet his retirement needs?
20,040.11
Using the three-step method to solve.
Step 1: Inflate needs until retirment:
| PV | = −40,000 |
| n | = 20 |
| i | = 2 |
| FV | = 59,437.90 |
Step 2: Discount annual needs to beginning of retirement:
| BEG mode | |
| PMT | = 59,437.90 |
| n | = 25 |
| i | =[(1.06 ÷ 1.02) − 1} × 100 (inflation-adjusted discount rate) |
| PVAD | = 973,006.62 |
Step 3: Determine the annual funding requirement:
| END mode | |
| FV | = 973,006.62 |
| PV | = −12,000 |
| n | = 20 |
| i | = 8 |
| PMT | = 20,040.11, or $20,040.11 |
ABC Company purchased a key employee life insurance policy with a face amount of $500,000 on one of its top executives, Roberta. ABC paid premiums of $50,000 on the policy during Roberta's employment with the company. When Roberta retired, she bought the policy from ABC for $60,000 and named her daughter, Teresa, as beneficiary. Roberta paid additional premiums of $20,000 on the policy before she died. Which of the following statements regarding this key employee life insurance policy are CORRECT?
2, 3, and 4
Roberta's purchase of the policy from ABC Company is not subject to the transfer-for-value rule because the transferee (Roberta) is the insured under the policy. Therefore, the entire death benefit is excluded from Teresa's gross income. Key employee life insurance covers employees who are considered critical to the success of the business. The business owns the policy, pays the premiums, and is the beneficiary; however, the premiums are not tax deductible but the death benefit is received by the company tax free if it still owns the policy when the insured dies.
Eugene is considering purchasing shares in XYZ stock that has a 20% probability of experiencing a negative 10% return, a 40% probability of experiencing a positive 8% return, and a 40% probability of experiencing a positive 12% return. If Eugene has a required rate of return of 6.5%, should he invest in the stock?
No, XYZ stock's expected return of 6.00% is below Eugene's required rate of return of 6.5%.
The expected rate of return for XYZ stock is 6%, calculated as follows: (0.20 × −0.10) + (0.40 × 0.08) + (0.40 × 0.12) = 0.06, or 6%. Therefore, Eugene should not purchase the stock because the expected rate of return is lower than his required rate of return.
When monitoring the financial news, Gary, a CFP® professional, is alerted to possible loss issues for one of his clients, Gordon. Gordon has multiple investments in shares of companies that as an industry is suffering losses in sales. Gordon has resisted Gary's recommendations to diversify his holdings in this industry. Gordon's income and his overall invested assets could be affected if the share values decrease substantially and dividend income is reduced. In one company, Gary feels Gordon's investment could become worthless in a few months. Gary's next regularly scheduled appointment with Gordon is in 4 months to review his financial situation. Regarding Gordon's circumstances, what should Gary do next?
Gary should assume the shares will decline in value and, for their next meeting, develop new recommendations to accommodate the change in Gordon's circumstances.
Gary should call Gordon and ask for an appointment to discuss the potential losses in Gordon's investments.
Gary should make a note to Gordon's file, reminding Gary to ask Gordon during their next meeting whether the adverse financial news in Gordon's preferred industry affected Gordon's circumstances.
Gary need not do anything because it stands to reason that Gordon will notify Gary if Gordon is adversely affected.
Gary should call Gordon and ask for an appointment to discuss the potential losses in Gordon's investments.
Gary should call Gordon and ask for an appointment to discuss the potential losses in Gordon's investments because planning may be needed to adjust the recommendations currently in place. Gary should not make any assumptions without discovering if there are, or could be, any changes in Gordon's circumstances because of the financial news. Community news is one resource for the CFP® professional to use when monitoring events that could affect a client. This financial reports and their relevance to the client's investments should trigger a request for a meeting from the planner. (Domain 7: Monitoring the Financial Planning Recommendations)
Ron owns several properties as follows:
If Ron dies today, what is the value of the property that must pass through probate?
$164,400
Property owned as JTWROS passes by right of survivorship to the surviving joint owner(s) and avoids probate. The vacation home Ron owned as fee simple and his interest in the house he owned as tenant in common with his brother, John, will pass through probate. The value of the real estate for the purposes of probate is $164,400 ($102,000 for the vacation home + $62,400 for Ron's share of the house owned as a tenant in common with John).
Eric, a CFP® professional, meets with new client, Allison, who is prepared to use his planning services to develop a budget. Allison brings to the meeting a list of her monthly nondiscretionary and discretionary expenses:
| Nondiscretionary | Discretionary | |||
| Utilities | $350 | Health club dues | $75 | |
| Rent | $1,100 | Entertainment | $150 | |
| Premium cable/internet | $200 | Dining out | $200 | |
| Insurance premiums | $400 | Tickets - sporting events | $150 | |
| Clothing | $120 | Cell phone service | $180 | |
| Food | $500 | |||
| Taxes | $450 | |||
Assuming he has all of the other information needed to prepare a budget, which of the following should Eric do next?
Clarify why Allison has included clothing and cable/internet services as nondiscretionary expenses
Track expenses by category and by month over the previous year
Prepare a budget for Allison based on the information gathered after moving the clothing and premium cable/internet expenses to the discretionary category
Recommend that Allison reduce or eliminate her discretionary expenses and invest the savings
Clarify why Allison has included clothing and cable/internet services as nondiscretionary expenses.
Eric should clarify why Allison believes the clothing and premium cable/internet are nondiscretionary expenses. Although Eric may believe the premium cable/internet service and monthly clothing purchases are nonessential and discretionary, there may be a reason, such as an employment-related need, to include these expenses as nondiscretionary. Once these classifications are clarified, Eric can proceed with tracking Allison's expenses.
Question ID: 959755
Debbie, age 46, works for XYZ Fan Corporation in the warehouse. She earns a salary of $66,000 per year and has a group disability insurance policy that pays 50% of her salary in the event of her total disability. Her company pays 70% of the premium and she pays the remainder. One Wednesday afternoon, while she is driving the forklift, a stack of wood pallets falls on top of her and she becomes permanently disabled. Debbie is in the 24% marginal income tax bracket. Which of the following statements is(are) CORRECT?
1 and 2
Debbie's net after tax income if she becomes disabled would be $27,456, calculated as follows:
$66,000 × 50% = $33,000 total benefits
70% employer paid percentage × $33,000 = $23,100 taxable portion of benefits
$23,100 × 24% marginal income tax bracket = $5,544 income tax
$33,000 − $5,544 = $27,456 net after-tax income
Workers' compensation benefits are received free of federal income tax. Debbie would not be eligible for Medicare benefits until she received Social Security disability benefits for at least 24 months.
Carmen and Doug are meeting with their CFP® professional, Geoff, to discuss the purchase of a stock for their long-term investment portfolio. Based on the information gathered from their previous interviews, Geoff has narrowed down the choices to two stocks with significant growth prospects.
| ABC | XYZ | |
| Current market price | $46 | $18 |
| Annual dividend growth rate | 4% | 5% |
| Current annual dividend | $1.25 | $0.45 |
| P/E ratio | 20 | 13 |
| Beta | 1.45 | 1.27 |
Assuming the client has a required rate of return of 7%, which stock should they choose for the portfolio?
XYZ because the stock is trading at a price less than the intrinsic value.
According to the constant growth dividend discount model, XYZ stock is undervalued with an intrinsic value of $23.62 when compared to its current market value of $18. ABC stock is overvalued at a current market price of $46 and an intrinsic value of $43.33.
Calculations:
ABC: V = $1.25(1.04) ÷ (0.07 − 0.04) = $43.33
XYZ: V = $0.45(1.05) ÷ (0.07 − 0.05) = $23.62
Martha owns stock for which she paid $10,000 at the time of purchase 3 years ago. She is considering selling the stock this month for a gain of $5,000. This year, she has also sold her personal residence which she has owned and lived in for 10 years for a gain of $75,000 over the purchase price. She is concerned about her current tax situation and the fact she has $80,000 of realized income in addition to her salary of $100,000 in the same tax year. Martha has consulted you, a CFP® professional, for advice. Which of the following are recommendations you should make to Martha?
2 and 4
Statements 2 and 4 are correct. Realization of income may occur on a specific transaction, but it may not have to be recognized (reported for tax purposes) at the same time. The $75,000 gain on the sale of her home is Section 121 gain and is excluded from her income because she owned and lived in the home for 10 years (ownership and use tests). Section 1244 stock rules apply to losses on the sale of the Section 1244 stock, not gains. However, any gain on the sale of the Section 1244 stock is long-term capital gain and taxed at the special long-term capital gain rate. Martha will only recognize the gain on the sale of the stock, not the residence sale gain. (Domain 5 - Communicating the recommendations)
Joe, age 49, has fallen behind on his mortgage payments by $16,000 and his mortgage company is threatening him with foreclosure even though his mortgage balance is only $25,000. His home is worth $300,000. He has not found a lender who will extend him credit. He comes to you for help. You notice that he has a Section 401(k) plan with $50,000, but it does not offer loans. His retirement plan balance is composed of:
| Employee Contributions | $ | 17,000 |
| Earnings on Employee Contributions | $ | 4,000 |
| Employer Contributions | $ | 21,000 |
| Earnings on Employer Contributions | $ | 8,000 |
What do you advise Joe in this situation?
He may be able to take a hardship withdrawal to get caught up on the mortgage.
Some retirement plans offer hardship withdrawals to employees who do not otherwise qualify for a distribution but who have an immediate and heavy financial need. Hardship withdrawals are limited to the worker contributions. The earnings on worker contributions and all money attributed to employer contributions are not eligible for a hardship withdrawal. One of the allowed hardship withdrawal reasons is to prevent foreclosure on a principal residence. Hardship withdrawals are always limited to the amount of the immediate and heavy need (plus the taxes on the withdrawal). Joe needs $16,000 to prevent eviction. He has $17,000 of employee contributions. Thus, he would only be eligible for a $17,000 hardship withdrawal. Also, this distribution will be taxed and 10% penalized as an early withdrawal. Rule 3.7 says a CFP® professional may not lend money to a client unless the client is an immediate family member or the CFP® professional works for a lending institution and the institution is lending its money to the client. Rule 3.6 says a CFP® professional may not borrow from a client except in the same circumstances (immediate family member or institutional lending). Using a spouse to attempt to get around these rules will not work.