Free Series 7 Taxation Practice Questions

Topic summary

Taxation questions usually turn on the account type, product type, holding period, income character, or cost basis. Identify what is being taxed before choosing the rate, exemption, or deferral treatment.

Common traps

• Treating all municipal bond income as free from every tax layer.
• Ignoring whether a retirement distribution is qualified, deductible, or tax deferred.
• Confusing capital gains with ordinary income.
• Forgetting that tax treatment never makes an unsuitable product suitable.

Free sample questions

1. A customer buys an in-state municipal bond issued by the customer's state of residence. How is the interest generally treated for federal income tax purposes? Correct answer: Exempt from federal income tax. Municipal bond interest is generally exempt from federal income tax. State and local treatment depends on the issuer and the customer's residence.
2. Interest received from a corporate bond is generally taxed to an individual investor as what? Correct answer: Ordinary income. Corporate bond interest is generally taxable as ordinary income. Do not apply municipal tax-exempt treatment to corporate debt.
3. An investor buys stock at $40 and later sells it at $55 in a taxable account. What has the investor realized? Correct answer: Capital gain. Selling a security above cost basis creates a realized capital gain. The holding period determines whether the gain is short-term or long-term.
4. A customer sells stock for a gain after holding it for 6 months. How is the gain generally classified? Correct answer: Short-term capital gain. A holding period of one year or less generally produces a short-term capital gain, which is taxed at ordinary income rates.
5. A Traditional IRA funded with deductible contributions generally produces what tax result when qualified distributions are taken? Correct answer: Distributions are taxed as ordinary income. Deductible Traditional IRA contributions grow tax deferred. Qualified distributions are generally taxed as ordinary income when withdrawn.
6. A qualified Roth IRA distribution is generally treated how for federal income tax purposes? Correct answer: Tax free. Roth IRA contributions are made with after-tax dollars. Qualified Roth distributions are generally federal income tax free.
7. A customer writes a call option that expires unexercised. The premium received is generally treated as what? Correct answer: Short-term capital gain. When a written option expires, the writer generally recognizes a short-term capital gain equal to the premium received.
8. Why does cost basis matter when a customer sells a security in a taxable account? Correct answer: It determines the realized gain or loss. Capital gain or loss is measured against cost basis. Suitability and tax treatment are separate issues; basis does not make a recommendation suitable.
9. Qualified dividends paid to an individual investor in a taxable account are generally taxed at which type of rate? Correct answer: Preferential capital-gain rates. Qualified dividends generally receive preferential tax treatment compared with ordinary income, assuming the requirements are met.
10. A high-tax-bracket customer compares a taxable corporate bond with a tax-exempt municipal bond. Which concept is most useful? Correct answer: Tax-equivalent yield. Tax-equivalent yield helps compare taxable and tax-exempt income for a customer's tax bracket. It is useful, but suitability still requires risk, liquidity, and objective review.