CFP - Investment Planning (17% of the exam) - Section D.34

Investment strategies

Active versus passive, value versus growth, dollar-cost averaging, buy-and-hold, tax-loss harvesting, laddering, barbell and bullet bond strategies, and hedging with options. Items ask which strategy best serves a client's stated objective, constraint and tax position.

Tax-loss harvestingWash sale rule

Practice question for this objective

Free sampleInvestment Planninghard

Elena, aged 61, lives in a state that levies no income tax and is in the 32 percent federal marginal bracket. Her planner is comparing a general obligation municipal bond yielding 3.20 percent, the interest on which is exempt from federal income tax, with an investment grade corporate bond of similar maturity and credit quality. Ignoring the net investment income tax and any transaction costs, what pre-tax yield must the corporate bond offer for Elena to be indifferent between the two?

A4.71 percent Correct
B2.18 percent
C4.10 percent
D4.22 percent

Compute a taxable equivalent yield by dividing the tax exempt yield by one minus the investor's stated marginal tax rate, then confirm it in reverse. The taxable equivalent yield grosses a tax free yield up by the reciprocal of one minus the marginal rate: 3.20 percent divided by (1 minus 0.32) equals 3.20 divided by 0.68, which is 4.7059 percent, rounding to 4.71 percent. Checking it the other way round, a corporate yield of 4.7059 percent taxed at 32 percent leaves 4.7059 multiplied by 0.68, which is 3.20 percent after tax and matches the municipal yield exactly. Because Elena's state levies no income tax, the usual second step of adding a state rate for an in-state issue does not apply, so the comparison turns on the federal rate alone. Had she lived in a state that taxed interest, an in-state issue would be exempt at both levels while an out-of-state issue would be exempt only federally, which changes the divisor.

Why A is correct: Correct. Dividing the tax free yield by one minus the marginal rate gives 3.20 divided by 0.68, which is 4.7059 percent, or 4.71 percent rounded, the taxable yield that leaves 3.20 percent in Elena's hands after federal tax.

Why B is wrong: This is 3.20 multiplied by 0.68, which converts a taxable yield into an after-tax yield. It runs the adjustment backwards, since the municipal yield is already an after-tax figure and has to be grossed up rather than reduced.

Why C is wrong: This is 3.20 divided by 0.78, grossing the yield up at a 22 percent rate. The taxable equivalent yield uses the investor's marginal rate on the next dollar of interest, which the stem states is 32 percent, rather than a lower bracket rate.

Why D is wrong: This is 3.20 multiplied by 1.32, adding the marginal rate to the yield instead of dividing by one minus the rate. The shortcut looks close at low rates but understates the gross-up, and the error widens as the marginal rate rises.

See more CFP practice questions, answers explained.

Exam traps in Investment Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

Approximately $509.09
Why it is wrong: This is what a candidate gets by correctly splitting the coupon into twenty semi-annual payments of $30 but then discounting each one at the full annual rate of 8% per period instead of 4% per period, which roughly doubles the discounting applied and produces a value far below any realistic market price for an investment grade bond.
Stock B offers the better relative value, because its price/earnings multiple of 14 is less than half of Stock A's and a lower multiple means a cheaper share.
Why it is wrong: A price/earnings multiple compares price with current earnings and says nothing about how fast those earnings are expected to grow, so treating the lower multiple as decisive ignores the growth rate that the PEG ratio exists to incorporate.
The loss stands, because the wash sale rule compares purchases and sales made inside the same account and the Individual Retirement Account is a separate account.
Why it is wrong: Account separation is the usual assumption and it is wrong here: the rule looks at the taxpayer's acquisitions of substantially identical securities, including those made inside her retirement account.

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