Tough Question on Retirement Accounts

Let's look at a tough practice question early on a Saturday morning:

Which of the following are examples of tax-free withdrawals from a Traditional Individual Retirement Arrangement for an individual 52 years of age?
I. first-time purchase of a primary residence
II. certain medical expenses
III. certain educational expenses
IV. series of substantally equal periodic payments under IRS Rule 72t

A. I, II, III
B. II, III
C. I, II, III, IV
D. none of the choices listed

Did you choose Answer C? No? Answer A? Maybe you saw the trap and chose the correct answer, which is Answer . . . D. None of the choices listed. See, the four Roman numerals given are examples of penalty-free withdrawals from an IRA, but, the more important concept is that withdrawals from your Traditional IRA are taxable. If they come out prior to age 59 1/2 they are also penalized, unless there is a provision allowing the individual to take out some money without paying that penalty. If you want to take up to $10,000 out of your IRA to buy your first residence, you will not be penalized; however, you will add the $10,000 to your taxable income for the year and pay your marginal tax rate on it. Same for the other three choices. Not all questions are trick questions, but you need to look them over to make sure there is not a trick before proceeding. If you would like more information on IRA's use the link below. If it doesn't work, click on the title of this post and then type in "publication 590" at the IRS website. I think the following link will take you right to the publication, though: http://www.irs.gov/pub/irs-pdf/p590.pdf

Sales Charges vs. Operating Expenses

Sales charges and operating expenses are two different things. Sales charges are an extra fee added to the price of mutual fund shares when the investor purchases them. They go to the underwriter and the broker-dealers and agents in the distribution network. Sales charges cover the costs of printing the prospectus and other sales literature, sending it out in the mail, paying agents and broker-dealers to sell the shares, and doing all the advertising that we see in magazines and hear on the radio these days. Do all funds have sales charges? No. The ones that do not impose sales charges are called "no load" funds. But, whether there is a "load" or not is one issue. The other issue is this: all mutual funds have operating expenses. Management fees cover the investment adviser who trades the portfolio. Accounting, legal, consulting, board of director and other expenses are usually lumped under "other expenses" in the prospectus. And, even though the fund calls itself "no load" it can still tack on another operating expense called a "12b-1 fee" that covers the costs of distributing/marketing the fund shares. The 12b-1 fee can not exceed .25% of the average net assets, but as long as it doesn't, the fund can call itself "no load." So, not all funds have sales charges, but all funds impose operating expenses. Many people think they don't pay ongoing fees to hold their fund shares, but that' s because they don't get a bill. The fund just reaches into the big cash register and pulls out enough cash to cover the operating expenses mentioned above. Again, sales charges are not operating expenses. They are tacked onto the price of an A-share when the investor purchases or subtracted from the proceeds of a B-share when the investor sells. Either way, the fund takes out operating expenses along the way, including the management fee, the 12b-1 fee, and all "other expenses."

Convertible Preferred Securities in the Real World

Reading my Chicago Sun-Times this morning, I noticed that when we talk about the federal government "bailing out the big banks" like Bank of America and Citigroup, we're really talking about convertible preferred securities.
Seriously. The federal government likes to provide capital/cash to banks in exchange for convertible preferred stock. While the bank struggles to get back on its feet, the federal government receives a fixed income stream on the preferred stock and then, should the bank eventually find its footing, the common stock rises, the federal government converts to common stock, and realizes a nice "profit" for taxpayers sitting back virtually clueless about the whole thing. Does it ever work out as planned? Sure, when the federal government guaranteed loans for Chrysler last time they threatened to go belly up, the government got an equity kicker. When the company recovered, and the common stock rose, the government exercised their warrants and realized a big profit for taxpayers.
Isn't this a great country? What, you thought our elected officials in Washington were just winging it? Not necessarily. Warren Buffet put $5 billion into Goldman-Sachs 10% convertible preferred stock back in September, which means Berkshire-Hathaway (of which I own 2 B-shares) receives $500 million per year in dividend income while they wait for Goldman-Sachs' common stock to rise above the conversion or strike price on the upside. What could lay such plans to waste?
The b-word, bankruptcy. $500 million in dividends per year sounds great, until the company goes belly-up and causes a wicked loss of maybe 80-90% of $5 billion. Ouch.
Of course, that's how it would play out at Berkshire-Hathaway, a profit-making enterprise. With the folks in Washington, they're all playing with the house's money, known as our tax dollars.

Buy Stops, Buy Limits

So, I guess I have to follow that last post with a discussion of buy-stop and buy-limit orders. Let's say you've been watching Starbucks lately. It last traded at $9.58 on Friday, so for whatever reason this price intrigues you. But, just like the older folks who attended my garage sale last autumn, you can't just buy something on the cheap. You insist on buying it even cheaper. No matter what price tag somebody sticks on a stock or a used waffle iron, frugal folks like you still insist on buying the thing a little cheaper. Fine. If you insist on buying Starbucks (SBUX) for $8 or lower, place a buy-limit order @8. Once you do that, you'll be in a position to buy SBUX as soon as the ask price drops to $8 or lower. What if the price drops to $8 or lower, filling your order, but then keeps dropping to, like $3, or, like, $1? At that point you would be crying and wishing you had placed a buy-stop order instead. Why? With SBUX trading at $9.58 a share, let's say you were intrigued but still nervous about the company's near-term prospects. There's a recession on, and it's not that hard for most people to cut back on their unnecessary spending. So, you're not ready to dive in, especially when you could see that stock dropping down to the low single digits. Then again, it's a great company, and as soon as the employment rate picks up again and wages start rising, people will probably go back to their old coffee and latte habits. So, you decide to play it both ways. You refuse to buy the stock if it's dropping from here. But, if it rises to a certain target point, you buy it automatically. The stock has to show you it has legs first, in other words, and only then will you buy it. Won't you end up paying more that way? Yes. If you enter a buy-stop @12 on SBUX, you will end up paying $12 if the stock rises to that point. On the other hand, if the stock drops quickly to $2 or $3 from here, you won't touch it. This example isn't just academic for me. I help a good friend manage his IRA. He's normally very sensible, but when he saw SBUX trading in the high teens a few months ago he was convinced he needed to buy it. I was convinced that Starbucks was entering a period of scary pain that would last at least 3 - 5 years, possibly ending in bankruptcy. With the stock at $17, I didn't recommend buying it at all, but I could only get him to compromise on placing a buy-stop @20. If the stock had risen from there, he would have bought it. Of course, we just saw that the stock has dropped to the $9 range and may well drop further. The buy-stop @20 never executed and then dropped off after 6 months. Thank God for buy-stop orders. They put the investor in a position to buy stocks that are rising in value, avoiding stocks that are dropping in value. If, on the other hand, you place a buy-limit order, you will buy the stock only if and only as it is dropping. Kind of a dangerous game if you think about it, like trying to catch a falling knife.

Sell Stops, Sell Limits

People are often confused by the difference between sell-stop and sell-limit orders. And, for some reason, some candidates actually start to confuse stop and limit orders with options, which would be sort of like confusing an airplane with a cheeseburger. Options are derivative securities. When we discuss "stop" and "limit" orders, we're talking about a method of buying and selling. Stop and limit orders can be used to buy and sell stock or options, but they are not investments, remember. They are types of orders. The easiest way to place an order to buy or sell stock is a "market order." There is a market price for the security; a market order gets filled at the best price the market will currently bear. So, if the exam question says that the customer primarily wants his order to be filled, choose the market order. It will be filled as fast as possible at the best price currently available. Stop and limit orders are specialized. The customer names a price at which something needs to happen. If the stock never reaches that price, nothing happens. For example, let's say you bought 1,000 shares of ABC common stock @20 back in 1998. Today the stock trades for $48, and you see from your notes that your target price was $50 for that stock back when you bought it. It's only $2 away from the target you had for selling, so you can enter a sell-limit order @50. You will not accept one penny less than $50 a share, but if somebody is willing to pay $50 or more, you will sell automatically. Notice how the stock price has to rise for the sell-limit order to execute. What if the price does not rise? Nothing happens to your stock. If you had marked the sell-limit order "good for the day," it would go away. If you had marked it "good 'til canceled" or "GTC," the order would remain on the books. What if the stock had dropped? It would have dropped. A sell-limit order is placed above the current market price and, therefore, only goes off if the stock rises. If the stock drops, the investor wishes he would have placed a sell-stop order, instead. Why? A sell-stop order provides protection. With the stock sitting at $48, you were sitting on a potential capital gain of $28 per share. If you had wanted to protect that paper gain, you could have placed a sell-stop order @45. At that point if ABC had dropped to $45 or lower, your shares would have been sold automatically to protect most of your gain on the stock. If the stock had risen or at least stayed above $45, you would have continued to hold it. See the big differences between the sell-limit and the sell-stop order? If the investor uses a sell-limit order, she really wants to sell her stock. She just wants a few dollars more. Unfortunately, she gets no protection against a drop in price. On the other hand, if the investor uses a sell-stop order, she does not necessarily want to sell. What she wants is to have her cake and eat it, too. She wants to hold the stock as long as it cooperates, but she wants it sold automatically at the first sign of trouble. Sell-limits are placed above the current market price for the stock. Sell-stops are placed below the current market price for the stock. What about buy-limits and buy-stops? Let's save that excitement for another post. It's barely 6 AM on a cold Sunday morning in Chicago. I don't want to overdo it.

Are they an investment adviser?

There is a subtle but important difference between an exclusion and an exemption. When the exam talks about investment advisers who are "exempt," they are referring to investment advisers who are not required to register.
Period.
In other words, these entities are definitely investment advisers because they provide financial planning services or manage portfolios or act as consultants. They simply don't have to register. For example, if you're an investment adviser in Wauwatosa, Wisconsin, a few of your financial planning clients might one day wake up on a cold February morning and in a moment of clarity move the hell out of the upper Midwest. Let's say that five of your clients move to Arizona--do you have to register in Arizona to keep serving them?
No. You would claim the "de minimis" exemption that says you're exempt from Arizona registration requirements based on two important facts: 1) you have no place of business in the state of Arizona and 2) you have no more than 5 non-institutional clients in the state.
On the other hand, there are entities that simply do not meet the definition of "investment adviser." They are excluded from the definition, in other words. A bank is not an investment adviser. Neither is a bank holding company. Many bank holding companies and banks are related to an investment advisory subsidiary (Wells Fargo/Wells Capital Management), but the bank is not the adviser, and neither is the bank holding company that sits above the other entities. A lawyer who talks about the value of securities only so far as his profession requires him to is not an investment adviser.
It probably seems hard to believe that this difference between exemptions and exclusions could actually matter, but it actually does. When the Investment Advisers Act of 1940 says that something is prohibited of "any investment adviser," it means that if you meet the definition of "investment adviser," this is a prohibition for you, even if you don't have to register. In other places, "the Act" uses language like "it shall be prohibited for any investment adviser registered or required to be registered under this Act," which means exactly what it implies--if you're exempt from registration, this rule does not apply.

Anyway, fun stuff to be sure, which is why I decided to share it with the community so early on a Friday morning. On another note, today's Friday Free Broadcast covers FINRA/SRO rules and reg's, which is actually a big topic on the Series 65 and 66 exams--pull down a Friday Free Broadcast schedule on the home page of our websites under Get Free Stuff.

Securities must be registered

A second ago I was doing some research for a caller asking about solicitors for investment advisers in the State of Texas. As usual, I got distracted by something else at the Texas State Securities Board's website, and I wanted to share the following with the community. It's very easy to read, and it makes some important points about securities in terms of how they're defined and how much trouble you could get yourself into by violating registration requirements:

In recent years licensed insurance agents nationwide have been recruited by promoters of illegal schemes to sell unregistered investment products to the public in Texas and elsewhere. These products have included promissory notes issued or guaranteed by offshore entities, brokered certificates of deposit, contracts for the sale and leaseback of telephone and ATM equipment, and resort "timeshare" investments. Typically these schemes have been directed at senior citizens. As under the federal securities law, the Texas Securities Act defines the term "security" broadly to encompass virtually any instrument that might be sold as an investment. The law requires that securities and persons offering securities for sale in Texas must be registered with the Securities Commissioner unless a specific exemption from registration applies. It is a third degree felony for a person to violate a registration requirement.

Notice how the way an "instrument" is offered and sold is material to determining if the "instrument" is, in fact, a "security." This explains why the SEC has recently included certain equity indexed annuities under the definition of a "security," due largely to the method that the EIA's are marketed and sold. If the EIA is marketed as a product with some upside, and with an uncertain return over the years, and if it's offered as a way to replace other securities investments . . . well, that was close enough for the securities regulators.

So, there are very few investments that do not meet the definition of a "security." Whole life, term life, and fixed annuities are not securities. Commodities futures contracts are not securities. Fully insured bank CD's are banking products. But even in those cases, read the facts presented in the test question very carefully as you try to determine what is and is not a "security."

In the real world, consult an attorney. Seriously. I wouldn't sell shares of an S-corp to your brother-in-law without first digging into your state's securities regulations and paying an attorney to advise you.

Mutual Fund A, B, C Shares, UITs, etc.

When you recommend mutual funds to investors, part of your suitability obligation is to help determine the proper share class. An investor with, say, $100,000 and a long time horizon should be purchasing A-shares. She will knock down the front-end sales charge with her quantity purchase, and her expenses going forward will be significantly lower than on B- and C-shares. B-shares are suitable for an investor with a long time horizon and a smaller amount to invest. This investor will avoid the front-end sales charge, and as long as she holds the shares 6 or 7 years, the back-end sales charge will go away, and then her shares will convert to A-shares with their lower operating expenses. She will pay higher operating expenses, but due to her small amount of $ to invest, she couldn't reach a breakpoint on A-shares, anyway. This is her best option. C-shares charge high operating expenses, and, unlike B-shares, these things do not convert to A-shares. So, they are generally for investors with a short time horizon. We don't want to keep hitting them with high annual expenses for very long, but if the investor will only hold the shares, say, three years, C-shares are ideal. No need to hit her up with a big front-end sales charge if she's only going to hold the fund a few years. As long as the investment is under, say, $500,000, C-shares will be suitable for a short-term investment. And that implies that a larger investment--even over the short-term--would be more suitable in A-shares, since the front-end load would be knocked down so low and then the investor would also enjoy the low operating expenses going forward. In other words, it's freaking complicated. And that's why many firms end up getting fined millions of dollars and returning millions of dollars to over-charged customers. They don't have adequate training and supervision in place. The rep's don't know enough about the various share classes, or maybe--just maybe--they prefer making the highest compensation possible, regardless of what's best for the customer. When you read the news release at the link below, please know that I am absolutely not bashing Wachovia here--heck, I'm a Wells Fargo shareholder (they own them now), and I also sell a lot of Pass the 65 and 66(c) books, DVD's etc. to Wachovia employees all across the country. Every firm out there could provide us with dozens of similar fines and mishaps--the securities industry is complicated. No one can stay on the right side of the regulatory line all the time. I don't see a need to explain the UIT angle, since the FINRA news release does such an excellent job of bringing up the testable points. Check out the news release at :
http://www.finra.org/Newsroom/NewsReleases/2009/P117836

Income Statement and Balance Sheet

The Series 65 and 66 will likely ask several questions requiring you to know the difference between a company's income statement and balance sheet. A company's income statement shows the results of operations over a financial quarter or over the fiscal year. It starts with revenue then deducts every cost and expense including taxes until we get to the "bottom line," known as "profit" or "net income after taxes." If you want to see the company's sales (revenue) and profits, look on the income statement.
If you want to see the company's financial health, look at the balance sheet. The balance sheet is a snapshot of the company's financial condition. Assets such as cash and securities, inventory, and equipment are listed on the "plus side," with liabilities such as deferred wages and accounts payable listed on the "minus side." The difference between a company's assets and liabilities is the net worth of the company, called "stockholders' equity" or "shareholders' equity."
Who reads income statements and balance sheets? Fundamental analysts. A fundamental analyst looks at the fundamentals of the company, including: revenue, earnings-per-share, book value, dividend payout, and profit margins. A fundamental analyst studies financial statements. He or she could invest in growth stocks, value stocks, a blend of each, whatever. But if he arrives at his stock picks through this school of thought, he is a fundamental analyst, and he is an active investor. A passive investor would not try to pick one company over another--he or she would use indexes almost exclusively.
Many students struggle with the difference between fundamental and technical analysis. We've already sketched fundamental analysis. Notice how it involves looking at a company's fundamentals. Technical analysis, on the other hand, studies the market data connected to the stock itself. A technical analyst doesn't care what the company makes or does, he just tracks the movement of the company's stock in terms of price, volume, and other market data. If he's talking about support and resistance, the 200-day moving average, or a head-and-shoulders pattern, he's a technical analyst. He's just tracking the stock price or movement of a particular index. A fundamental analyst, on the other hand, studies a particular company or industry sector in terms of sales, profits, growth trends, etc.

Unregistered, non-exempt securities

First, I want to say CONGRATULATIONS to one of our three current followers-of-the-blog. In case he's a humble guy I won't name him, but I hope he'll comment to this post to take credit for GETTING A 91% ON THE SERIES 66 exam. Maybe he has a few tips and/or warnings for those brave souls about to face the opponent at the testing center.

Wow. 91%. Way to go, (name withheld for now).

Second, I want to prove to you that what you're studying under the "Uniform Securities Act" and SRO regulations is directly related to the so-called "real world." I remember the first time I heard an instructor imply that the phrase "soliciting sales of unregistered, non-exempt securities" has "nothing to do with the real world."

Wrong.

Way wrong.

If you click on the link below you will see just how seriously you could mess up your career if you sold unregistered securities. I'll let you experience this one in the native tongue. If you have questions, as always, please post them.

http://www.finra.org/Newsroom/NewsReleases/2009/P117712

Statute of limitations

Keep emailing your questions. As you can see, students bring up issues that the whole community may be working on.

QUESTION:
Question ***** states that the investor has 6 years to bring suit. What happened to 2 years from discovery or 3 years from trade and 5 years for criminal statute of limitations?

RESPONSE:
Another good one, Helen. 5 years is for criminal prosecution. If I swindle investors here in Chicago, the IL Attorney General or Cook County State's Attorney has 5 years to bring a criminal case against me. If I'm a swindled investor, I can sue the sellers/promoters in civil court if I bring suit within 2 years of discovery/never more than 3 years from the event.

Then there is an SRO called NASD/FINRA. FINRA has an arbitration procedure (not civil court). A client has 6 years to file a claim before the more informal arbitration panel. There are no appeals in arbitration, unlike in civil court. Of course, FINRA is only an option if you're going after a registered person/firm. Civil court is there for all the crazy offerings of securities by individuals and businesses who are not registered. Jimmy's Juice Bar offers "promissory notes" to gullible investors--they're not a broker-dealer registered with anyone. The investors who lose money on the fraudulent offer of "securities" can try to recover what they paid, plus interest, in civil court. And, good luck to those poor saps, who will likely never see a dime.

An agent terminates from a broker-dealer

QUESTION:
I have been doing the tests; one of the questions is: An agent in the state is fired, who has to notify administrator? Help!!

RESPONSE:
This is actually easier than it seems.
The question usually goes like this: If an agent is terminated by a broker-dealer in the state and takes a position with another broker-dealer in the state, who must notify the Administrator? Answer: both broker-dealers and the agent. What this means is the broker-dealer from whom he is terminating files a U-5 (which the agent fills out, too), and the new firm fills out a U-4 (which the agent fills out, too.) BTW, you can look at these forms at http://www.nasaa.org/ under "industry and regulatory resources" then "uniform forms."

Here is what the Uniform Securities Act has to say about this topic:
Sec. 201. [REGISTRATION REQUIREMENT.] (a) It is unlawful for any person to transact business in this state as a broker-dealer or agent unless he is registered under this act.
(b) It is unlawful for any broker-dealer or issuer to employ an agent unless the agent is registered. The registration of an agent is not effective during any period when he is not associated with a particular broker-dealer registered under this act or a particular issuer. When an agent begins or terminates a connection with a broker-dealer or issuer, or begins or terminates those activities which make him an agent, the agent as well as the broker-dealer or issuer shall promptly notify the [Administrator].

Gift tax question

QUESTION: Taxation question (loophole or just plain bad news?): If Parents of client want to give money to their child, can they give it by paying off things like the child's house, car, etc? Or will it be subject to taxes?

RESPONSE: One the one hand, parents can give their children as much money as they want--but if they give more than the "annual gift tax exclusion," the excess is subject to gift taxes. For 2008, the maximum was $12,000; for 2009, it's $13,000. So, if the parents give each child $13,000 this year, there is nothing to file, and no gift taxes to pay. If they give them $100,000 each, the excess is subject to gift tax rates. Paying off a car loan would not qualify for an exception to gift tax rules, as far as I know--though I'm not a CPA or tax professional. The exceptions that the test might bring up would include paying someone's tuition or medical expenses--these don't count as gifts as long as the payment is made directly to the education or medical provider. So, to wrap up--if the "kid" owes $13,000 on the car, the parents can either pay the holder of the loan or give the "kid" $13,000. They don't have to worry about gift taxes based on the size of the gift. The purpose of the gift isn't relevant here. If the loan is more than $13,000, though, the excess above the annual gift tax exclusion is subject to gift taxes. Also, if husband and wife file separately on their income taxes, they can each give the kid $13,000. See http://www.irs.gov/ and search on "gift taxes," for more information on that. Just wondering, have the parents considered letting their kids pay their own damned bills? There are charities that try to cure cancer, help the homeless, feed the hungry, etc. Not really what you're asking, of course, and probably not what your clients would want to hear. It probably does explain why I don't work directly in the financial services industry--not sure that clients would want to hear the unvarnished truth and sarcasm never seems to work successfully as a sales tool.

If you pay someone a referral fee do they have to be registered?

QUESTION: If you pay someone a referral fee do they have to be registered? Can they be a client and also get paid a referral fee? I know this all has to be disclosed to clients but if you could help me on the rules.

RESPONSE: in nearly every state, if the investment adviser pays a referral fee to anyone, that individual or firm is required to register as a "solicitor" or an "investment adviser representative." On the exam, you'll probably get a question about a real estate professional or CPA who receives a referral fee in exchange for recommending that clients use the services of an investment adviser. If so, tell the test that this individual or firm should register as an investment adviser representative of that IA. In the real world, I believe there are five states that do not require solicitors to register--instead, they would hold the adviser responsible for the solicitor's activities. I believe Missouri is one of the five states with no registration requirement for solicitors. In that case, the adviser would simply need to be sure that the solicitor is not someone who has been disciplined by securities regulators, convicted of any felony or any securities-related misdemeanor in the past 10 years. The solicitor needs to deliver the adviser's ADV Part 2 (disclosure brochure) and also a copy of the solicitor's brochure that explains to the prospect the details of his relationship to the adviser. In most states the solicitor needs to be registered as a representative of the IA. In a handful of states, registration is not required.