AFC Investment and Retirement Planning 5 — Questions and Answers
Question 1: A client has a traditional IRA with a basis of $20,000 and a current value of $100,000. They withdraw $10,000. How much of the withdrawal is taxable?
- $10,000
- $2,000
- $8,000 (Correct answer)
- $0
Correct answer: $8,000
Using the pro-rata rule, 20% of the IRA is basis ($20k/$100k), so 20% × $10,000 = $2,000 is tax-free and $8,000 is taxable.
Question 2: Which investment vehicle offers a step-up in cost basis at the account owner's death, making it advantageous for estate planning?
- Traditional IRA
- Roth IRA
- Taxable brokerage account (Correct answer)
- 529 college savings plan
Correct answer: Taxable brokerage account
Assets in a taxable brokerage account receive a stepped-up cost basis to fair market value at the owner's death, potentially eliminating capital gains tax on appreciation.
Question 3: What is the primary purpose of a Qualified Longevity Annuity Contract (QLAC) within a retirement account?
- To eliminate RMDs entirely from a traditional IRA
- To defer income and RMDs on a portion of IRA funds until as late as age 85 (Correct answer)
- To provide long-term care benefits tax-free
- To convert IRA funds to Roth tax-free after age 70
Correct answer: To defer income and RMDs on a portion of IRA funds until as late as age 85
A QLAC allows up to $200,000 of IRA funds to be excluded from RMD calculations until annuity payments begin, which can be deferred until age 85.
Question 4: In Modern Portfolio Theory, the efficient frontier represents portfolios that:
- Maximize return for any given level of risk (Correct answer)
- Minimize taxes for any expected return level
- Generate the highest alpha relative to a benchmark
- Eliminate unsystematic risk through diversification
Correct answer: Maximize return for any given level of risk
The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk.
Question 5: A client exercises non-qualified stock options (NQSOs). When does ordinary income tax apply?
- At the time the options are granted
- When the options vest
- When the options are exercised (spread between FMV and strike price) (Correct answer)
- Only when the shares acquired are sold
Correct answer: When the options are exercised (spread between FMV and strike price)
With NQSOs, ordinary income tax is triggered at exercise on the spread between the fair market value and the exercise price.
Question 6: Which of the following is a characteristic of a defined benefit pension plan?
- The employer bears the investment risk (Correct answer)
- The employee controls asset allocation
- Benefits depend on account balance at retirement
- Contributions are made solely by the employee
Correct answer: The employer bears the investment risk
In a defined benefit plan, the employer promises a specific benefit and bears the investment risk to fund that obligation.
Question 7: A 40-year-old client asks about the '4% rule' for retirement withdrawals. What does this rule suggest?
- Invest 4% of income annually to retire comfortably
- Withdraw 4% of the initial portfolio value annually, adjusted for inflation, for a 30-year retirement (Correct answer)
- Limit equity allocation to 4% of the retirement portfolio
- Earn at least 4% real return before retiring
Correct answer: Withdraw 4% of the initial portfolio value annually, adjusted for inflation, for a 30-year retirement
The 4% rule, from the Trinity Study, suggests withdrawing 4% of the initial portfolio in year one and adjusting for inflation annually has historically supported a 30-year retirement.
AFC Investment and Retirement Planning 5
A client has a traditional IRA with a basis of $20,000 and a current value of $100,000.
They withdraw $10,000.
How much of the withdrawal is taxable?