Types of Accounts

• Cash Account
  • Buyer pays full amount of trade
• Margin Account
  • Long – client borrows funds from the broker-dealer to purchase securities
  • Short – client borrows securities from the broker-dealer to sell short
• Options Account

Opening a Margin Account

• Margin
  • Increases customer purchasing power
  • Increases risk of large losses due to adverse market changes
  • Subject to Regulation T deposit requirement of 50%
    • If you want $20,000 of securities, you need to put up $10,000
• Credit Agreement (mandatory)
  • The terms of the loan
  • Discloses interest amount, how computed, and when charged
• Hypothecation (Pledge) Agreement (mandatory)
  • Customer hypothecates securities to B/D as collateral
  • B/D borrows money from a bank to replace the loan that was made to the customer
    • Borrows client stock on behalf of the client as collateral 

Additional Margin Documents

• Loan Consent Agreement (generally used for short sales)
  • Not mandatory for opening account
  • If signed, B/D is able to lend the customer’s securities to others
• Margin Disclosure Document – must be provided to all customers opening a margin account and indicates:
  • A customer can lose more money than deposited
  • The firm can force the sale of securities or assets in the account
  • The firm can sell securities from the account without notifying the customer
  • The customer has no control over which assets are sold to meet a margin call
  • The in-house maintenance requirement can be changed without prior written notification to the client
  • The client is not entitled to an extension for a margin call

Determine which document it describes

• Indicates that the broker-dealer is permitted to use securities in the margin account to secure a loan
  • Hypothecation agreement
• Discloses the interest rate, how it’s computed, and when it’s charged
  • Credit agreement
• States that secruities can be sold from the account to meet a margin call
  • Margin disclosure document
• States that a broker-dealer is permitted to lend securities in a margin account to others
  • Loan consent agreement 

Opening an Options Account

• Due to high risk in option accounts, option trading may not be suitable for all clients
• Firms must gather client information through Option Account Agreement, including:
  • Names of those with trading authority
  • Financial status, objectives, experience
    • Data need not be verified
• If the client does not provide requested information, a note is made on the agreement
• A copy is sent to the client for his eventual signature (verification) along with the OCC’s options disclosure document (ODD)

Discretionary Account

• If a client is to authorize another person (usually the broker) to make investment decisions in her account or deposit and/or withdraw funds, the following forms/steps are required:
  • An authorization form signed by the client and the person granted authorization (Power of Attorney)
    • Principal must approve the account in writing prior to its opening
    • Each order must be reviewed and approved promptly by a principal (not in advance)
    • Activity must be monitored for potential churning
• Limited Trading Authorization
  • Allows for execution of trades
• Full Trading Authorization
  • Allows for execution of trades, withdrawal of cash and securities, check-writing privileges

Power of Attorney

• Grants a person other than the account owner with the authority to act on the owner’s behalf without the owner’s prior knowledge  

Not Held Orders

• The Three “A”s
  • For Not Held orders, the customer specifies the Action, the Amount, and the Asset
• Allows client to provide oral authorization for trade execution
• Avoids the need for discretionary authority if RR decisions are limited to time and/or price of execution
• Client specifies whether to buy or sell, the quantity, and the security
  • “Sell 1,000 shares of XYZ whenever you think the time and price is right”
• Not Held orders are only good for one day; if longer, written authorization is required

Fee-Based Accounts

• Advisory and custodial fees, along with transaction costs, are wrapped into one comprehensive annual fee
  • Traditional accounts charge on a per transaction basis assessing a commission on each trade
  • Fee-based accounts roll all of the costs for services into one fee
    • Wrap accounts are a type of fee-based account
• Suitability considerations
  • Are the services appropriate given the client’s needs?
  • Are the fees reasonable given the client’s trading history?
    • Unsuitable for clients who trade infrequently (Buy and Hold)
    • Designed primarily for active traders

Education Savings Plan

• Coverdell Education Savings Account (CESA)
  • A trust or custodial account that’s created for the purpose of paying the qualified education expenses of a designated beneficiary
    • Maximum contribution: $2,000 annually per child up to age 18
    • Contribution is non-deductible, but earnings are tax-free if used for qualified education expenses (contribution eligibility is subject to income limits)
    • CESAs may be used to pay for private education on any level (i.e., kindergarten through college)
    • Funds must be used by the child’s 30th birthday or transferred to a relative’s CESA
• 529 Plan
  • A plan that is generally operated by a state and designed to meet the costs of both college and K-12 education
  • Allows for much larger contributions than what CESAs allow
  • Covered in great detail in Chapter 8

For which type of investor is a fee-based account unsuitable?

• Fee-based accounts are unsuitable for investors who follow a buy-and-hold strategy 

How much and for how long can contributions be made to a CESA

• Individuals can contribute a maximum of $2,000 annually per child up to age 18

Which educational savings plan is primarily designed for higher education?

• 529 plan

Customer Account Registrations

• Individual
• Joint
• Custodial (minor)
• Fiduciary
• Corporate
• Partnership

Individual Account

• Opened by, and for, one person
• Only the account owner can dictate trades
  • Third party authorization may be granted to another person
• Numbered or Nominee accounts are permitted
  • The account may be opened under a number or code name
  • Provides privacy for the individual
  • Customer Identification Program (CIP) requires firms to maintain records of the beneficials owners

Joint Account

• New account information is obtained for each owner
• Any owner may initiate activity
• When signatures are required, all owners must sign
• Checks are made payable to all parties
• Joint Tenants with rights of survivorship
  • Common for spouses
  • Each tenant has equal ownership
  • If one owner dies, ownership passes equally to surviving tenant(s) without probate
• Joint Tenancy in Common
  • Common for business partners
  • Each tenant owns a specified amount
  • If one owner dies, decedent’s portion is transferred to her estate (your will)

Trust Account

• Trust – a legal arrangement in which an individual (creator) gives fiduciary control of property to a person or institution (trustee) for the benefit of beneficiaries
• Revocable  – also referred to as living or inter vivos trusts
  • A person has the ability to revoke or change any terms in the trust
  • Does not reduce estate taxes, but avoids probate if funded prior to donor’s death
• Irrevocable trust
  • Cannot be changed after being signed
  • Will reduce estate taxes and avoid probate

Accounts for Minors – UGMA/UTMA

• Custodial account – uses a standard new account form titled “custodian for minor”
• One Minor (Legal Owner)
  • Responsible for taxes; minor’s social security number
  • If child dies without a will, state law determines asset distribution
• One Custodian (Any Adult)
  • Has authority to initiate activity (prudent (wise) investments)
  • Under the Uniform Prudent Investor Act (UPIA), a custodian may delegate investment functions to a third party
• GIFTS
  • Irrevocable; may be cash and/or securities
  • Covered options and penny stock transactions may be permitted
  • No margin (i.e., no uncovered options,short sales,c commodities)
  • No limit on number of donors or on the value of gifts
  • Taxes may be due from donors if gifts exceed $17,000 per year

Other Forms of Registration

• Fiduciary
  • A fiduciary is defined as a person or organization that owes to another the duties of good faith and trust
  • Documentation is often filed with a court in order to get court approval of the actions of the fiduciary
• Corporate/Institutional Accounts
  • Always examine Corporate Resolution
  • To open an option or margin account, the Corporate Charger must also be examined
• Partnership
  • Partnership agreement specifies person authorized to execute trades
  • Information must be collected on each managing partner

Matching

• Revocable
  • The terms of the trust account can be changed
• UTMA
  • There is only one custodian and gifts are irrevocable
• Individual
  • Only the account can dictate trades
• JTWROS
  • If a tenant dies, ownership passes equally to the surviving tenants
• JTIC
  • If a tenant dies, the decedent’s portion is transferred to her estate

Traditional and Roth IRAs

• For both Traditional and Roth:
  • Early withdrawal penalty
    • Before age 59 ½ and 10% of taxable amount
      • In a Roth IRA, the first contribution must have been made at least five years prior
    • Exceptions: death, disability, qualified higher education expenses, up to $5,000 each (spouse) for expenses associated with birth or adoption of a child, or qualified first-time homebuyer distributions ($10,000 lifetime limit)
• Rollovers and Transfers (no penalty)
  • Rollover
    • Owner receives proceeds
    • Once per year (rolling 12 months); completed within 60 days
  • Trustee-to-Trustee Transfer:
    • Owner does not have access to the funds
    • May be more than once per year

Taxation of Traditional IRAs

• (Funded with after-tax contributions)

• Tax-deferred earnings: Only earnings are taxable as ordinary income

Determine whether true/false

• If an individual has earned income, he can contribute to a traditional IRA
  • True
• Required minimum distributions must be made from a Roth IRA after the owner reaches age 73
  • False, this is for traditional IRA
• Earnings can be withdrawn from a traditional and roth IRA without penalty for first-time homebuyers
  • True
• Qualifying distributions from a Roth IRA are tax-free
  • True

ERISA

• Employee Retirement Income Security Act of 1974 was created to prevent misuse and mismanagement of pension plan funds
  • Rules apply to private sector defined benefit and defined contribution plans
  • Determines qualified status
    • Employer and employee contributions are tax-deductible
    • Earnings are typically tax-deferred
  • Plans must not be discriminatory and offered to all employees who:
    • Are age 21 or older
    • Have at least one year of full-time services (1,000 hours)
  • An approved vesting schedule must be followed
    • Specifies the percentage of the employer’s contributions to which the employee is entitled when withdrawing from the plan
    • Employees are 100% vested in their own contributions

Taxation of Retirement Plans

• Tax status of contributions
  • Pre-tax contributions have a zero cost basis (taxable at withdrawal)
  • After-tax contributions are part of cost basis (tax-free at withdrawal)
• Earnings typically grow tax-deferred
• Retirement plans never generate capital gains or losses
• Tax status of distributions:
  • Any portion representing pre-tax contributions is taxable as ordinary income
  • Any portion representing after-tax contributions is a return of capital and not taxed
    • Earnings are typically taxed as ordinary income
  • Subject to required minimum distributions (RMD)

401(k) and Profit Sharing Plans

• Employees may elect to contribute (generally pre-tax)
  • Generally have a zero-cost basis since they are funded with pre-tax contributions, with earnings that grow tax-deferred
  • Contributions are subject to a maximum annual amount
• Employers may match contributions but are not required to do so
  • Matching may be based on a profit-sharing plan
• Employers that maintain 401(k) plans must have a dual eligibility requirement under which employees are eligible if they satisfy either
  • A 1 year of service requirement (or 1,000 hours) or
  • Three consecutive years where the employee provided at least 500 hours of service
• Profit-sharing Plans
  • Contributions are discretionary, decided by the board of directors
  • Contributions are subject to a maximum annual amounts
  • Allocation of contributions to employees is based on a predetermined formula

What type of plan will permit an employer to match funds?

• 401(k)