20 Tax, Retirement Plans & ERISA Practice Questions & Answers

1. 1. A client holds shares of a publicly traded equity REIT in a taxable brokerage account and receives regular distributions paid out of the REIT's taxable income. How are those ordinary distributions generally treated on her federal return?

   • A.They are exempt from federal income tax at the shareholder level, because the REIT already paid an entity-level tax on that income.
   • B.They are treated as a nontaxable return of capital that simply reduces the client's cost basis in the REIT shares.
   • C.They are taxed at long-term capital gains rates as qualified dividends, provided the dividend holding period is satisfied.
   • D.They are taxed as ordinary income at her marginal rate, since such REIT distributions are not qualified dividends.✓ Answer

   A REIT escapes entity-level tax by distributing nearly all of its taxable income as a conduit, so the income passed through to shareholders was never taxed at the corporate level. Qualified dividend treatment is reserved for dividends paid out of income that has already borne corporate tax, which is why ordinary REIT distributions are taxed at the shareholder's ordinary income rates rather than at capital gains rates.

   Source: IRC Section 857 (taxation of real estate investment trusts); IRC Section 1(h)(11) (definition of qualified dividend income)Report a problem with this question

2. 2. A client buys 200 shares on March 10 of one year and sells all of them at a gain on March 9 of the following year. Assume long-term treatment requires a holding period of more than one year. How is the gain taxed?

   • A.As a long-term capital gain at preferential rates, because the sale occurred in the calendar year after the purchase.
   • B.As a long-term capital gain at preferential rates, because the holding period includes the purchase trade date itself.
   • C.Half as short-term gain and half as long-term gain, because the position straddled two of the client's tax years.
   • D.As a short-term capital gain at ordinary income rates, because the position was held for one year or less.✓ Answer

   The holding period begins the day after the purchase trade date and ends on the trade date of the sale, so a sale on March 9 of the following year leaves the position held one year less a day. Because the stated requirement of more than one year is not met, the gain is short-term and is taxed at ordinary income rates; crossing into a new calendar year is irrelevant to the measurement.

   Source: IRC Section 1222 (definitions of short-term and long-term capital gain and loss)Report a problem with this question

3. 3. A client sells a bond fund at a loss on November 1 and repurchases the same fund on November 20. Assume the wash sale rule disallows a loss when substantially identical securities are acquired within 30 days before or after the sale. What is the consequence for the client?

   • A.The loss is allowed in full, because the repurchase occurred in the same calendar year as the sale.
   • B.The loss is disallowed this year, and the disallowed amount is added to the basis of the repurchased shares.✓ Answer
   • C.The loss is permanently forfeited, and no adjustment is made to the basis of the repurchased shares.
   • D.The loss is allowed, but the repurchased shares must be assigned a new short-term holding period from the repurchase date.

   The wash sale rule defers rather than destroys the loss: the disallowed amount is added to the cost basis of the replacement position, so the deduction is recovered when that position is eventually sold outside a wash sale window. The replacement shares also inherit the holding period of the shares that were sold, which is why an adviser harvesting losses must avoid repurchasing a substantially identical security inside the stated window.

   Source: IRC Section 1091 (losses from wash sales of stock or securities; basis adjustment under Section 1091(d))Report a problem with this question

4. 4. A client is deciding whether to give a long-held, highly appreciated stock position to her son during her lifetime or to leave it to him at her death. Setting transfer taxes aside, how does the son's income tax basis differ between the two routes?

   • A.A lifetime gift carries over his mother's basis, while property inherited at death takes a basis equal to its value at death.✓ Answer
   • B.A lifetime gift gives the son a basis equal to fair market value on the date of the gift, while an inheritance carries over her basis.
   • C.Both routes give the son a basis equal to fair market value on the date of transfer, so the choice has no income tax effect.
   • D.Both routes give the son his mother's original basis, so the entire unrealized gain is taxed to him whenever he sells.

   Property received by gift keeps the donor's basis, so the donee ultimately pays tax on all of the appreciation that built up in the donor's hands, while property acquired from a decedent takes a basis equal to its value at death and that built-in gain disappears. This is why advisers generally steer highly appreciated, low-basis holdings toward the estate and use higher-basis assets for lifetime gifting.

   Source: IRC Section 1015 (basis of property acquired by gift); IRC Section 1014 (basis of property acquired from a decedent)Report a problem with this question

5. 5. An adviser is harvesting losses in a client's taxable account near year end. How are the client's realized capital gains and losses netted for the year?

   • A.Short-term losses offset short-term gains and long-term losses offset long-term gains, and any net loss then crosses over.✓ Answer
   • B.All losses are applied against ordinary income first, and only the unused remainder is netted against gains.
   • C.Losses may be netted only against gains realized on securities in the same industry sector as those sold.
   • D.All losses are applied against long-term gains first, because those gains are taxed at the most favorable rates.

   Capital gains and losses are netted by character first, short-term against short-term and long-term against long-term, and only the resulting net amount in one category is carried across to offset the other. That ordering is what makes harvesting effective: a short-term loss is most valuable when it shelters a short-term gain that would otherwise be taxed at ordinary income rates.

   Source: IRC Section 1222 (character netting of capital gains and losses); IRC Section 1211 (limitation on capital losses)Report a problem with this question

6. 6. A client in a high marginal bracket holds general obligation municipal bonds in a taxable account and sells several of them for more than she paid. Which statement about the federal tax treatment is correct?

   • A.The interest is exempt from federal income tax, but the gain realized on the sale is a taxable capital gain.✓ Answer
   • B.The interest and the gain are both taxable, but she may claim a federal credit for the state taxes she pays.
   • C.Both the interest and the gain on the sale are exempt from federal income tax because the issuer is a municipality.
   • D.The interest is taxable as ordinary income, while the gain on the sale is exempt under the bond's tax-favored status.

   The federal exemption attaches to the interest a state or local issuer pays, not to the bond itself, so a municipal bond remains an ordinary capital asset in the owner's hands. Selling it above cost therefore produces a taxable capital gain, short- or long-term depending on the holding period, which is why after-tax comparisons of municipal holdings must separate coupon income from price appreciation.

   Source: IRC Section 103 (interest on state and local bonds); IRC Section 1221 (definition of capital asset)Report a problem with this question

7. 7. A traditional IRA holds a stock position the client has owned for many years and that has appreciated substantially. She asks whether selling it inside the IRA and later withdrawing the proceeds produces long-term capital gains treatment. What should the adviser explain?

   • A.Distributions of pre-tax IRA money are ordinary income, so the long-term character of the internal gain is lost.✓ Answer
   • B.The sale inside the IRA is itself a taxable event in the year it occurs, reported at long-term capital gains rates.
   • C.The withdrawal is tax free, because tax was already paid on the appreciation when the position was sold in the IRA.
   • D.Withdrawals attributable to positions held more than a year keep long-term capital gains treatment on her return.

   Transactions inside a tax-deferred account are not taxable events, and when money finally comes out of a traditional IRA it is taxed as ordinary income without regard to how the earnings were generated inside. This character conversion is a core asset-location point: assets that already enjoy preferential capital gains rates gain less from being sheltered than assets throwing off ordinary income.

   Source: IRC Section 408(d)(1) (taxation of distributions from individual retirement accounts as ordinary income under Section 72)Report a problem with this question

8. 8. An employer is comparing a traditional defined benefit pension plan with a defined contribution profit-sharing plan. Which statement correctly describes where investment risk falls under each?

   • A.In a defined benefit plan the employee bears the investment risk of the account balance; in a defined contribution plan the employer does.
   • B.In both plans the employee bears the investment risk, because the ultimate benefit depends on how the invested assets perform.
   • C.In a defined benefit plan the employer bears the investment risk of funding the promised benefit; in a defined contribution plan the employee does.✓ Answer
   • D.In both plans the employer bears the investment risk, because the employer chooses and monitors the plan's investment options.

   A defined benefit plan promises a formula benefit, so poor investment results force the employer to contribute more to keep the plan funded, and the employer absorbs the shortfall. A defined contribution plan promises only the contribution, so the participant's retirement income is whatever the account grows to and the participant absorbs both good and bad market outcomes.

   Source: ERISA Section 3(34) (individual account plan) and Section 3(35) (defined benefit plan)Report a problem with this question

9. 9. A public school teacher participating in her employer's 403(b) tax-sheltered annuity asks her adviser what she may hold inside the plan. Which answer is correct?

   • A.Direct interests in real estate limited partnerships are permitted if the plan document allows them.
   • B.Individual common stocks that the participant selects are permitted alongside annuity contracts.
   • C.Annuity contracts and mutual funds held through a custodial account are the permitted investments.✓ Answer
   • D.Securities that the participant's brokerage firm is able to custody may all be held in the plan.

   A 403(b) arrangement may be funded with annuity contracts or, through a custodial account, with shares of regulated investment companies, and Congress deliberately confined the menu to those two vehicles. Individual stocks, limited partnership interests and other direct holdings fall outside that statutory list, so a recommendation of them inside a 403(b) is not merely unsuitable but impermissible.

   Source: IRC Section 403(b)(1) (annuity contracts) and IRC Section 403(b)(7) (custodial accounts invested in regulated investment company stock)Report a problem with this question

10. 10. A city employee defers salary into her employer's governmental 457(b) plan and also works a second job at a nonprofit that offers a 403(b) plan. How do the elective deferral limits interact?

    • A.She may not defer into both plans in the same year, because the plans are sponsored by different employers.
    • B.Her governmental 457(b) deferrals fall under a limit separate from the one shared by 401(k) and 403(b) plans.✓ Answer
    • C.Her 457(b) and 403(b) deferrals are aggregated under a single limit that applies across all of her employers.
    • D.Her 457(b) deferrals reduce dollar for dollar the amount she may defer into the 403(b) plan in the same year.

    Elective deferrals to 401(k), 403(b) and SARSEP arrangements share one annual ceiling, but a governmental 457(b) plan is governed by its own separate deferral limit rather than by that shared ceiling. A participant with access to both types of plan can therefore shelter substantially more salary in a single year than a participant with only a 401(k), which is a planning point advisers routinely miss.

    Source: IRC Section 402(g) (limit on elective deferrals) and IRC Section 457(e)(15) (separate limitation for eligible deferred compensation plans)Report a problem with this question

11. 11. A small business owner with several eligible employees establishes a SEP IRA. Which statement describes how the plan is funded and how contributions vest?

    • A.Employees make elective salary deferrals and the employer must match them dollar for dollar, and the match follows a graded vesting schedule.
    • B.The employer contributes a different percentage for each employee based on length of service, subject to a cliff vesting schedule.
    • C.The employer alone funds the plan, using the same percentage of compensation for every eligible employee, and contributions vest at once.✓ Answer
    • D.Both the employer and the employees contribute, and the employer's share vests only after a stated waiting period is completed.

    A SEP is funded entirely by employer contributions that must bear a uniform relationship to each eligible employee's compensation, so the owner cannot give himself a larger percentage than his staff receives. Because the contributions go into ordinary IRAs owned by the employees, they are fully vested the moment they are made and no vesting schedule is possible.

    Source: IRC Section 408(k) (simplified employee pension; employer contributions must bear a uniform relationship to compensation)Report a problem with this question

12. 12. A client is covered by a 401(k) at work, and her household income is well above the range in which the traditional IRA deduction phases out. She has substantial earned income. What may she do for the year?

    • A.She may contribute only if she stops making elective deferrals to her 401(k) plan for that same tax year.
    • B.She may neither contribute to nor deduct a traditional IRA contribution, because workplace plan coverage disqualifies her.
    • C.She may contribute and deduct the full amount, because the phase-out reaches only taxpayers with no workplace coverage.
    • D.She may contribute but may not deduct it, and the nondeductible amount becomes cost basis in the traditional IRA.✓ Answer

    Eligibility to contribute to a traditional IRA turns on having earned income, while the income phase-out limits only the deduction for an active participant in an employer plan. A nondeductible contribution is still permitted and is tracked as basis so that it is not taxed again when distributed, which is also what makes the pro-rata calculation necessary on any later conversion.

    Source: IRC Section 219(g) (limitation on deduction for active participants in employer plans); IRC Section 408(o) (nondeductible contributions)Report a problem with this question

13. 13. A client with a large pre-tax rollover IRA makes a nondeductible contribution to a traditional IRA and immediately converts that contribution to a Roth IRA. What determines how much of the conversion is taxable?

    • A.The pro-rata share of pre-tax dollars across all her traditional, SEP and SIMPLE IRAs sets the taxable portion.✓ Answer
    • B.Nothing is taxable, because a conversion made in the same year as the contribution is treated as a recharacterization.
    • C.The entire converted amount is taxable, because every Roth conversion is fully includible regardless of basis.
    • D.Nothing is taxable, because she may designate the newly contributed after-tax dollars as the amount converted.

    For distribution and conversion purposes all of a taxpayer's traditional, SEP and SIMPLE IRAs are treated as one account, so after-tax basis is spread proportionately and cannot be cherry-picked. A client who already holds a large pre-tax balance therefore finds most of a so-called backdoor conversion taxable, which is the single most common planning error with this strategy.

    Source: IRC Section 408(d)(2) (aggregation of individual retirement accounts in computing the taxable portion of a distribution or conversion)Report a problem with this question

14. 14. A client took a distribution from one of her IRAs four months ago and rolled it into another IRA within 60 days. She now wants to move assets from a third IRA to a different custodian. What should the adviser tell her?

    • A.She must wait twelve months from the earlier rollover before moving those assets by any method at all.
    • B.She may move the assets now only if the receiving custodian is the firm that received the earlier rollover.
    • C.She may take a second sixty-day rollover now, because the twelve-month limit is applied separately to each IRA.
    • D.A trustee-to-trustee transfer may be done now, because the twelve-month limit applies to indirect rollovers.✓ Answer

    The one-rollover-per-twelve-months restriction applies to indirect rollovers in which the owner takes possession of the money, and it is measured across all of the taxpayer's IRAs rather than account by account. A direct trustee-to-trustee transfer is not a rollover at all because the owner never receives the funds, so it may be done as often as needed.

    Source: IRC Section 408(d)(3)(B) (one rollover permitted in any one-year period, applied across all of a taxpayer's IRAs)Report a problem with this question

15. 15. A participant leaving her employer wants to move her entire 401(k) balance to an IRA. Assume the plan must withhold 20% for federal income tax on any eligible rollover distribution paid directly to her. Which approach best accomplishes her goal?

    • A.Take the check personally and roll over the net amount received, treating the withheld portion as a final tax payment.
    • B.Request a direct rollover payable to the IRA custodian, so nothing is withheld and the whole balance stays deferred.✓ Answer
    • C.Ask the plan to waive withholding, since it is optional whenever the participant states an intention to roll over.
    • D.Take the check personally, since the plan refunds the withholding once the rollover is completed within sixty days.

    Mandatory withholding attaches only when an eligible rollover distribution is paid to the participant, so a direct rollover made payable to the receiving custodian moves the entire balance with nothing withheld. If she takes the check instead, she must replace the withheld portion out of her own pocket within the sixty-day window or that portion becomes a taxable distribution.

    Source: IRC Section 3405(c) (mandatory withholding on eligible rollover distributions); IRC Section 401(a)(31) (direct rollover option)Report a problem with this question

16. 16. An adviser is explaining required minimum distributions to a client who owns both a traditional IRA and a Roth IRA. Which statement is correct as a matter of concept?

    • A.Required distributions apply equally to traditional and Roth IRAs, since both are tax-favored retirement accounts.
    • B.Required distributions are waived for any year in which the client is still working, whatever account holds the money.
    • C.Required distributions pull pre-tax balances into income over time, and a Roth IRA owner faces no lifetime requirement.✓ Answer
    • D.Required distributions may be satisfied only by selling securities, because in-kind distributions are not permitted.

    The purpose of a required minimum distribution is to stop indefinite deferral of tax on money that was never taxed, which is why the rules target pre-tax balances and why the distribution is ordinary income when taken. A Roth IRA was funded with after-tax dollars and there is no deferred tax to collect, so its owner is subject to no lifetime distribution requirement at all.

    Source: IRC Section 401(a)(9) (required minimum distributions); IRC Section 408A(c)(5) (Roth IRAs not subject to lifetime minimum distribution rules)Report a problem with this question

17. 17. A trustee of a private employer's 401(k) plan is selecting the plan's investment options. Under ERISA, what standard of care governs that decision?

    • A.The care that an ordinary prudent person would use in handling his or her own personal property and affairs.
    • B.The care set out in the trustee's own written service agreement with the plan's largest account holders.
    • C.The care customarily exercised by other employers of similar size operating in the same geographic region.
    • D.The care, skill and diligence that a prudent person familiar with such matters would use in a like capacity.✓ Answer

    ERISA measures a fiduciary against a prudent person who is familiar with such matters and acting in a like capacity, which courts read as a prudent expert standard rather than the ordinary prudent-person test of general trust law. That is why a plan fiduciary who lacks investment expertise is expected to hire it, and why the duty is owed to participants and beneficiaries rather than defined by any contract the fiduciary signs.

    Source: ERISA Section 404(a)(1)(B) (prudence standard applied in a like capacity by a person familiar with such matters)Report a problem with this question

18. 18. A plan sponsor's 401(k) is participant-directed, and the sponsor believes ERISA Section 404(c) shields it from liability. Which statement about the scope of that relief is correct?

    • A.Relief applies after the plan has run for a full year and the sponsor files a notice with the Department of Labor.
    • B.Relief covers every fiduciary decision about the plan once participants can direct their own accounts.
    • C.Relief covers losses from participants' own choices, but choosing and monitoring the menu stays fiduciary.✓ Answer
    • D.Relief extends to the choice of recordkeeper and its fees, as long as participants get quarterly statements.

    Section 404(c) relieves fiduciaries of responsibility for the results of instructions a participant actually gives, and only when the plan offers a broad range of alternatives, allows instructions with reasonable frequency and delivers the required disclosures. The act of assembling and then monitoring that lineup is itself a fiduciary act that the safe harbor never covers, which is where most participant lawsuits are aimed.

    Source: ERISA Section 404(c) and 29 CFR 2550.404c-1 (participant-directed individual account plans)Report a problem with this question

19. 19. A 401(k) participant is automatically enrolled and never gives investment instructions. For the plan to obtain fiduciary relief for investing her contributions by default, what must the default investment be?

    • A.A guaranteed contract selected by the recordkeeper, carrying a surrender charge on any early transfer.
    • B.A diversified, professionally managed option such as a target date fund, balanced fund or managed account.✓ Answer
    • C.A capital preservation vehicle such as a money market fund, held until she gives investment instructions herself.
    • D.A fund holding the employer's own stock, so that the default aligns her with the employer's performance.

    A qualified default investment alternative must be professionally managed and diversified so that a silent participant is placed in a mix appropriate for long-term retirement investing rather than in a cash-equivalent that is unlikely to keep pace with inflation. Employer securities are excluded, and the participant must be able to move out of the default during an initial window without any transfer restriction or fee.

    Source: 29 CFR 2550.404c-5 (qualified default investment alternatives under ERISA Section 404(c)(5))Report a problem with this question

20. 20. The owner of a company that sponsors a 401(k) plan proposes that the plan buy an office building from him at an independently appraised price. How does ERISA treat the proposal?

    • A.It is permitted, because an independent appraisal shows that the plan is paying no more than fair value.
    • B.It is prohibited, because a sale of property between the plan and a party in interest is barred outright.✓ Answer
    • C.It is prohibited only if the plan borrows money to fund the purchase of the building from the owner.
    • D.It is permitted, because a plan may hold real property with no percentage limit on employer real estate.

    ERISA bars a defined list of dealings between a plan and a party in interest, including any sale, exchange or lease of property, and the prohibition is structural rather than dependent on whether the price was fair. Because the employer and its owner are parties in interest, the transaction is prohibited on its face unless a statutory or administrative exemption applies, and the fiduciary who authorized it would be personally liable to restore any loss.

    Source: ERISA Section 406(a)(1)(A) (sale or exchange of property between a plan and a party in interest); IRC Section 4975 (prohibited transactions with disqualified persons)Report a problem with this question

Practice questions written from the NASAA Series 65 Test Specifications and the Uniform Securities Act. Not affiliated with or endorsed by NASAA, FINRA or Prometric. Dollar thresholds, fee figures and contribution limits change; where one matters the question supplies it. Confirm current requirements with NASAA before testing. NASAA exam content outline →