Taxable Account

A tax-sensitive investor in a taxable account may prefer ETFs over comparable mutual funds because ETFs are:

1. A.Exempt from all taxesETFs are taxed like any other security: dividends are taxable and sales produce capital gains. Their advantage is narrower, namely that in-kind redemptions usually prevent the fund from distributing capital gains to shareholders who did not sell.
2. B.Always cheaper to trade with no spreadETFs often do carry lower expense ratios, so the cost angle has some truth. Trading on an exchange means paying a bid-ask spread that mutual funds, priced once daily at NAV, do not impose, and the stem asks specifically about taxes.
3. C.Guaranteed to outperformStructure does not confer performance; an ETF and a mutual fund tracking the same index deliver nearly the same gross return. The tax-efficiency advantage shows up in after-tax return, not in outperformance.
4. D.Generally more tax-efficientCorrect - fewer taxable distributions.

Why: ETFs are generally more tax-efficient than comparable mutual funds due to their creation/redemption mechanism.

Hollis pays 700 dollars for a zero-coupon corporate bond with a 1,000 dollar face value and 10 years to maturity, held in a taxable account. Using straight-line accretion, what is his adjusted cost basis after four years?

1. A.700 dollarsThis assumes no accretion occurs until maturity. On a taxable OID bond the discount is accreted and taxed each year.
2. B.1,000 dollarsThis jumps to the full face value. Basis reaches face only at maturity, after all ten years of accretion.
3. C.820 dollarsCorrect. 300 / 10 = 30 dollars per year, and 700 + (30 x 4) = 820 dollars.
4. D.760 dollarsThis accretes for only two years. The stem asks for the basis after four years.

Why: The discount is 1,000 minus 700, or 300 dollars, spread over 10 years, so 30 dollars accretes each year. After four years 120 dollars has been accreted and reported as taxable interest income, and the basis rises correspondingly to 700 plus 120, or 820 dollars. The rising basis is what prevents that income from being taxed a second time as gain. Review original issue discount accretion in the debt securities topic.

Regarding the taxation of distributions from an equity REIT held in a taxable account, most ordinary distributions are:

1. A.Qualified dividends taxed at long-term capital gain ratesWrong-but-tempting. Qualified rates require corporate-level taxation that REITs avoid.
2. B.Tax-free returns of capital in all casesWrong. Return-of-capital is only the portion exceeding earnings, separately reported.
3. C.Ordinary income that does NOT qualify for the reduced qualified-dividend rateCorrect. The conduit structure disqualifies most REIT payouts from qualified treatment.
4. D.Municipal-style tax-exempt interestWrong. REITs distribute rental/operating income, never tax-exempt interest.

Why: Because REITs deduct distributions and avoid entity-level tax, their ordinary distributions do not qualify for reduced qualified-dividend rates; they are ordinary income to holders, though a portion may benefit from the Section 199A deduction, with capital-gain and return-of-capital components reported separately. Citation: IRC Secs. 857, 199A; IRS REIT distribution rules. Takeaway: REIT dividends = mostly ordinary income, not qualified.

A 30-year-old client intends to hold a mutual fund position for at least 20 years in a taxable account. Which share class is generally LEAST appropriate due to its ongoing cost structure over a long horizon?

1. A.Class A shares with a front-end load and low 12b-1 feesIncorrect - the one-time load plus low ongoing fees is often cheaper over 20 years.
2. B.Class C shares with a level load and high ongoing 12b-1 feesCorrect - perpetual high 12b-1 fees make C shares costliest over a long horizon.
3. C.No-load index fund sharesIncorrect - no-load, low-cost shares are well suited to a long horizon.
4. D.Institutional shares, if the minimum is metIncorrect - institutional shares carry the lowest ongoing costs when available.

Why: Class C shares carry high level 12b-1 fees every year, which compound to the greatest drag over a long holding period. For a 20-year horizon, A shares or no-load/institutional shares usually cost less overall despite any up-front load.