Free CFP flashcards

When employer stock is sold after a net unrealised appreciation election, which layer of gain is automatically long-term and which one carries its own holding period?

The election makes the plan cost basis ordinary income in the year of the lump-sum distribution and defers the spread between that basis and the distribution-date value until the shares are sold, at which point that spread is long-term capital gain no matter how briefly the shares were held. Growth arising after the distribution date is a separate layer, measured from the distribution date, so it takes the ordinary holding period rules and can be short-term.

The two Roth IRA five-year clocks run independently. What does each one actually control?

The contribution clock starts with the first contribution to any Roth IRA and only decides whether a distribution is qualified, which controls how earnings are taxed. The conversion clock runs separately from each conversion and only decides whether the 10 percent additional tax reaches converted principal taken out early, which is moot once the owner is past 59 and a half. Distributions then come out in order: regular contributions, then converted amounts oldest first, then earnings.

Common misconceptionFailing the contribution clock does not make converted principal taxable. That principal was already taxed in the year of conversion, so recovering it can never produce a second income inclusion under either clock.

Why is standard deviation, rather than beta, the right single statistic for a portfolio that is not diversified?

Total risk equals systematic risk plus unsystematic risk. Diversification is what removes the unsystematic component, and only after it is removed does systematic risk describe what the investor bears. In a concentrated holding the unsystematic component is still large, so standard deviation, which captures the whole dispersion of the portfolio's returns, is the measure of the risk actually carried.

How does setting a bond portfolio's duration equal to the investment horizon insulate a goal from interest rate moves?

Price risk and reinvestment rate risk pull in opposite directions. When yields rise, bond prices fall but coupons are reinvested at higher rates; when yields fall, prices rise but coupons earn less. Immunisation sets duration equal to the horizon so the loss on one side is approximately matched by the gain on the other, leaving the accumulated value at the horizon largely unaffected by the direction of rates.

Common misconceptionMatching final maturity to the goal date is not the same as immunising it. It fixes the redemption date, but coupons received before then must still be reinvested at unknown rates, so the accumulated sum stays exposed to a fall in rates.

Analysis of the current and alternative courses of action is finished. Which step comes next, and what makes it the next one?

Each step supplies the input for the one after it. Comparing the client's current course of action with the alternatives is what allows the planner to select a course of action and formulate it as a recommendation. Only once a recommendation exists can it be presented, and only once it is accepted and responsibilities are agreed can it be implemented.

Where in the Financial Planning process does a recommendation belong, and why can it not come first?

The Practice Standards run in a defined order because each step supplies the input for the next. A planner cannot know whether a joint life annuity serves a client until debts, employer benefits, health, risk tolerance and obligations to a disabled dependant are on the table. Committing a large share of a rollover balance to an illiquid income contract could conflict with that dependant's long-term support or with liquidity the client will need. Producing the recommendation first inverts the process, so the analysis, if it happens at all, is written to justify a decision already taken.

Common misconceptionFollowing reasonable client directions is genuinely a fiduciary duty, but it covers lawful directions about the client's affairs. It does not authorise skipping the analytical steps the Practice Standards require.

Which federal trial court hears a tax deficiency dispute before the taxpayer pays the disputed amount?

Three courts have original jurisdiction over federal tax disputes. The Tax Court hears a deficiency case on a petition filed within the statutory window after a notice of deficiency, and the tax need not be paid beforehand. The District Court and the Court of Federal Claims hear tax matters only as refund suits, so the assessed amount must be paid and then sued for. Cash flow rather than the merits is usually what drives the choice of forum.

How do the sources of federal tax authority rank, and what weight does a private letter ruling issued to another taxpayer carry?

The Internal Revenue Code sits at the top, Treasury regulations interpret it with general effect, and revenue rulings and revenue procedures state the position the Service will take generally. A private letter ruling answers one taxpayer's specific facts and binds the Service only in relation to that taxpayer, so it may not be used or cited as precedent by anyone else. Where a final regulation conflicts with a third party's private letter ruling, the regulation governs the planner's advice.

Common misconceptionA private letter ruling is genuine written guidance and it does bind the Service, but that binding effect runs only to the taxpayer who requested the ruling and only on the facts submitted.