Professor

What Are QIBs and Accredited Investors? What’s the Difference?

If you’re studying for securities licensing exams, such as the SIE or the Series 7, then you should understand the terms “accredited investor” and “QIB.” Continue reading

If you’ve been studying for the Series 7, 6, 14, 22, 24, 65, 79, or 82, or the Securities Industry Essentials (SIE), then you’ve had to learn about Regulation D private placements and Rule 144A sales. Regulation D private placements are securities offerings that are exempt from the normal SEC registration process and in many cases are sold only to “accredited investors” or limit the involvement of investors who are not accredited. Rule 144A sales are sales of unregistered securities to large institutional investors known as “qualified institutional buyers” or QIBs for short.

You may have wondered about the difference between accredited investors and QIBs. On the surface, these may seem similar. Each refers to a category of investor with resources and/or knowledge above and beyond the average retail investor. So why not just have one standard for buyers under both Rule 144A and Regulation D? After all, the purpose of both Regulation D and Rule 144A is the same: to allow wealthier and more sophisticated investors easier access to investments that may be too risky for the average investor.

To begin to answer this question, we have to start with the fact that wealth and sophistication fall on a spectrum. Investors aren’t neatly divided between small retail investors and huge financial institutions that move millions around without blinking an eye.

Accredited Investors

You could think of accredited investors as a middle ground between these two extremes. Accredited investors are investors whose financial status or investment knowledge may give them a greater ability to handle the risks inherent in a private placement. There are many ways to qualify as an accredited investor but they all have one thing in common, which is that the SEC believes they indicate an ability to take on risks that regulators believe are unsuitable for most retail investors.

Accredited investors are investors whose financial status or investment knowledge may give them a greater ability to handle the risks inherent in a private placement.

All of the following are considered accredited investors:

Banks, broker-dealers, investment advisers, insurance companies, and investment companies
Corporations, trusts, partnerships, and LLCs with more than $5 million in assets
Most employee benefit plans with more than $5 million in assets
The issuer’s directors, executive officers, and general partners
If the issuer is a privately owned fund, (such as a hedge fund), a knowledgeable employee of the fund, which means an employee with at least 12 months’ experience working on the fund’s investment activities
Individuals with income of $200,000 in each of the last two years, or $300,000 in combination with a spouse or spousal equivalent such as a domestic partner
Individuals with a net worth more than $1 million, alone or with a spouse or spousal equivalent, not including primary residence
Individuals who hold any of these three designations in good standing:
- Licensed General Securities Representative (Series 7)
- Licensed Investment Adviser Representative (Series 65)
- Licensed Private Securities Offerings Representative (Series 82)
Any firm where all owners are accredited investors (e.g., venture capital firms)
Any other entity with more than $5 million in investments that was not formed specifically to qualify as an accredited investor; the purpose of this category is to include entities that don’t neatly fit into any of the above categories, such as:
- Native American tribes
- Labor unions
- Government bodies, including those of foreign governments
- Investment funds created by government bodies
- New types of business entities that may be introduced by new laws

An accredited investor that is not an individual—such as a business, governmental, or nonprofit entity—is sometimes called an institutional accredited investor (IAI).

Qualified Institutional Buyers

QIBs are a narrower group of large institutional investors. A QIB is a large institutional investor that owns at least $100 million worth of securities, not counting securities issued by its affiliates. For registered broker-dealers, the threshold is lower, just $10 million. A bank must also have a net worth of at least $25 million in order to be considered a QIB.

If a firm has discretionary authority to invest securities owned by a QIB, those securities count toward whether the firm itself is considered a QIB. So if a broker-dealer has $9 million worth of securities in its own accounts, and holds $1 million worth of securities in a discretionary account belonging to a QIB, then the broker-dealer is itself a QIB.

Common examples of QIBs include broker-dealers, insurance companies, investment companies, pension plans, and banks. However, any corporation, partnership, or LLC could qualify as a QIB. So can an IAI that owns at least $100 million in securities. Individuals can never be QIBs, regardless of their assets or financial sophistication.

Individuals can never be QIBs, regardless of their assets or financial sophistication.

Rule 144A allows QIBs to buy unregistered securities at any time, and freely trade these shares to other QIBs. In effect, QIBs can trade unregistered shares among themselves with almost the same ease as trading registered shares. Selling unregistered securities to anyone other than a QIB commonly requires a the seller to hold the securities for a period of up to 12 months.

A QIB will virtually always meet the criteria to be an accredited investor, whereas an accredited investor may fall well short of QIB status.

Over time, other securities laws and regulations have made use of these two well-known categories. For example, in 2019 the SEC gave issuers more flexibility to test the waters with potential investors before deciding whether to go through with a public offering. When deciding which investors were sophisticated enough to receive test-the-waters communications, the SEC limited these communications to QIBs and institutional accredited investors. Additionally, references to institutional accredited investors have become more common, such as when the SEC revamped its rules around integration of offerings in March 2021.

Know your QIBs from your accredited investors and be ready to pass your securities exam with Solomon Exam Prep.

For more helpful securities exam-related content, study tips, and industry updates, join the Solomon email list. Just click the button below:

Join the list

Answering Suitability Questions on the FINRA Series 7

Suitability questions may appear daunting. But they don’t have to be – read the Solomon guide to answering suitability questions with ease. Continue reading

If you’re taking the FINRA Series 7 exam, you very possibly dread the term suitability. We understand that suitability questions may appear daunting. But to enhance your chances of passing the exam, you should have a good understanding of the concept and how it applies to certain test questions.

Suitability questions can be difficult because they often contain more than one answer choice that seems plausible. In short, they are more open-ended than other questions that appear on the exam. While this can make these questions tough, keep in mind that in each suitability question has one BEST answer given the information provided. This blog will help you select that that best answer choice.

First, what is a suitability question? The most basic type of suitability question presents a hypothetical investor and his profile and asks you which investment or investments is most suitable for him. Other suitability questions are about specific products. For instance, a question might ask you to choose the bond that would be most suitable for a high-income earner – usually a municipal bond. Finally, other types of suitability questions may provide an information about an investor and her profile and you will be asked which investments should be removed and/or added to her portfolio, or which proposed asset allocation is best.

So, what’s the best strategy for answering these questions?

1. Learn and memorize the characteristics of the investment products.

The most basic requirement for properly approaching any of these questions is to have a good understanding of the investment products mentioned in the question. Think about it this way: if you don’t know the characteristics a product, it’s difficult to know who should and shouldn’t buy it. For instance, if you don’t know the characteristics of a growth fund or a municipal bond it will be hard to assess which investors should own these products or avoid them in favor of other products. This means learning and memorizing the characteristics of the major investment products, such as stocks, bonds, funds, and options, is the first step to mastering suitability.

2. Categorize the investment goals of the investor in the question.

Assuming that you understand the products mentioned in a question, let’s look at what else you should consider when answering a suitability question. First, when reading a suitability question, focus on the financial goals attributed to the hypothetical investor presented in the question.

There are four major investing goals and strategies that you should keep in mind when doing this. First, there are capital preservation investors. These investors are interested in obtaining a minimum level of return while not putting their principal at any significant risk. Then there are the income investors. These want to receive a steady stream of payments in hopes of supplementing their income. Third, there are capital growth investors. These are long-term investors whose primary hope is seeing the value of their investments rise over time. Finally, there are the speculative investors. These investors are willing to take on more risk in the hopes of earning higher gains in a shorter amount of time. Placing an investor in one of these categories, or a blend of two of these categories, will help you figure out which investments are most suitable for the investor.

3. Analyze the profile of the Investor, looking for risk tolerance, time horizon and tax bracket.

Risk Tolerance:

Look for the investor’s risk tolerance. If an investor is not willing to take on much risk, only the most conservative investments are suitable for him. In contrast, an investor with a high risk tolerance is willing to own more volatile types of investments. Typically, conservative risk tolerance correlates with capital preservation investors, and sometimes income investors, while high risk tolerance correlates with speculative investors and many capital growth investors. Examples of conservative investments include U.S. Treasury securities, money market funds, and bank CDs. Examples of high-risk investments include penny stocks, options, junk bonds, and possibly growth stocks.

Time Horizon:

An investor’s time horizon is another factor you must consider. Is the investor hoping for long-term growth, or is he going to need to cash out of his investments in a relatively short amount of time? Sometimes a question will not present you with this exact information but instead will give an investor’s age. Questions that mention an investor who is in his 20s or 30s are indicating someone with a long time horizon. In contrast, questions that describe an investor who only has a few years until retirement are usually describing someone with a shorter time horizon. Scenarios that describe a couple who wants to buy a house or pay for college in the next year, will also have a short time horizon, and therefore, will require liquid investments.

So which investments are best for long- and short-term investors? An investor with a long time horizon is able to invest in products that are expected to grow over time, such as growth stocks, equity mutual funds and ETFs, or annuities. He is also more likely to take on riskier investments since he has more time to make up for any losses. On the other hand, a short-term investor should invest in less volatile securities or debt investments that mature in the near term, such as U.S. Treasuries and money market funds. An investor with a short time horizon is also less likely to take on a high level of risk than a long-term investor because a short-term investor does not have as much time to make up any losses.

Tax Bracket:

A final factor to consider when determining suitability is income level or tax bracket. An investor who makes a lot of money will typically have a higher federal income tax rate. This means the money he receives from his investments will be more heavily taxed than the money someone in a lower tax bracket. Additionally, for a high income investor, capital gains are taxed at a lower rate than interest income. Oftentimes, it is best to recommend investments with fewer tax implications for a high-income investor. Municipal bonds, whose interest payments are usually tax-free at the federal level and often also tax-free at the state level, are typically suitable investments for high-income investors. In contrast, because the interest rates for municipal bonds are often lower than the interest rates for corporate bonds, investors in lower tax brackets may be better off purchasing corporate bonds than municipal bonds. Additionally, stocks are often suitable for investors with higher tax rates because their gains are not taxed until the stocks are actually sold. At the same time, investments that pay regular interest, but do not come with tax advantages may not be suitable for high-income investors because they will have to pay taxes on this interest.

So now that you know what to look for in suitability-type questions, let’s look at a couple of them:

QUESTION ONE:

Mary is an investor in her thirties. She makes $50,000 a year and is hoping to find an investment that will provide capital appreciation. At the same time, she would not mind supplementing her income by receiving regular payments from her investment. Which of the following would be most suitable for her?

1. A municipal bond fund
2. A growth and income fund
3. A small-cap stock fund
4. Penny stocks

This question tells you Mary’s investment goals and objectives. She’s looking for capital growth and secondarily income, so she’s a blend between a capital growth and income investor. Additionally, since she’s in her thirties, you can assume that she has a relatively long time horizon. Finally, her low income means she is not in a high tax bracket.

You know that Mary needs an investment option that provides the potential for both capital growth and income payments. Both penny stocks and small-cap stocks carry the potential for capital growth; however, neither of them typically offers income payments. That is because neither penny stocks nor small-cap stocks pay meaningful dividends. This eliminates choices C and D. A municipal bond fund would provide income because municipal bonds make semi-annual interest payments. However, outside of high-yield bonds, bonds in general don’t offer much in the way of capital growth. Also, since interest from municipal bonds is generally not taxed at the federal level, municipal bond interest payments are lower than corporate debt securities and thus are not the best debt investment option for an investor who is not in a high tax bracket. Given all of this information, you can eliminate choice A as well. Now let’s look at choice B. A growth and income fund contains stocks with `capital growth potential along with stocks that provide regular dividend payments. Also, growth stocks are also good for investors like Mary who have long time horizons. Looks like you’ve found the correct answer: Choice B makes the most sense.

QUESTION TWO:

Alisha is 26 and has just received an MBA. She’s starting on a career as a sales manager at a large company and has a bright future. She has $15,000 to invest with your firm, and she tells you that she would like to see that principal appreciate as much as possible over the next two to three decades. She also says she has no problem taking on a high level of risk to help make that happen. Which of the following asset allocations would be most suitable for Alisha?

1. 20% income fund, 20% municipal bond fund, 20% fixed annuities, 20% dividend-paying stocks, 10% non-traditional ETFs, 10% cash
2. 20% bond mutual fund, 20% agency bonds, 10% money market funds, 15% bank CDs, 15% dividend-paying stocks, 10%, 10% cash
3. 30% large-cap stocks, 20% equity index mutual fund, 20% U.S. Treasuries, 20% AAA-rated corporate bond funds, 10% FDIC-insured bank CDs
4. 20% small-cap stocks, 20% medium-cap stocks, 20% growth fund, 15% high-yield bond funds, 15% balanced fund, 10% interval fund

Again, you’re presented with the investor’s investment goals and objectives in the question prompt. In stating that Alisha hopes to see her principal appreciate as much as possible over a long period of time, the question is telling you that she is a capital growth investor. It also is implying that she has a long time horizon. Additionally, it states that she is willing to take on a high level of risk in meeting her investing goals, which means she’s an investor with a high risk tolerance.

Given each of these factors, you need to look for the portfolio that makes the most sense for her. That portfolio should contain more equity investments than debt investments. That is because in general equities provide better capital growth potential than bonds. Additionally, you should look for investments that have higher growth potential and which carry more than a moderate level of risk. Remember that higher risk often equals higher potential reward, and Alisha is willing to take this gamble.

So let’s look at each of the possible answer choices.

Alisha isn’t really interested in earning income as part of her strategy and wants the potential for large gains. That means choice A, which is heavy on income and low-return investments, should be discarded. The same is true of choice B. Choice C is a bit tougher to eliminate. That’s because this hypothetical portfolio does include some growth-type investments, such as large-cap stocks and equity index mutual funds. However, these are both equity investments that are known to provide a more moderate return potential than Alisha is seeking. Additionally, choice C contains a relatively high percentage of fixed and low-return investments, and thus it doesn’t look like a great answer choice. That leaves choice D. The hypothetical portfolio presented in that answer choice is heavy on aggressive growth-type stocks and funds that carry a high level of risk, such as small-cap stocks, mid-cap socks, and growth funds. Additionally, a high-yield bond fund is a type of debt security that comes with capital growth potential. And it includes 10% allocation to an interval fund, a type of fund that invests in non-publicly traded securities that are illiquid and may be less correlated to the other publicly trade securities in this portfolio. Thus, choice D is the best choice and the correct answer.

Suitability questions are definitely not easy. But if you consider all of the relevant aspects presented in the answer choices and have a solid understanding of different types of investments, they are something you can master. And master them you must if you want to pass the Series 7 or the Series 6 exam.

For more helpful securities exam-related content, study tips, and industry updates, join the Solomon email list. Just click the button below:

Securities Exam Score Survey Results Are In

Do you think FINRA should provide exam scores to those who pass their qualification exams? Keep reading to learn the results of the Solomon survey. Continue reading

Solomon Exam Prep loves to hear customers’ opinions on all things securities exam-related. We recently conducted a LinkedIn poll about this question:

Do you think FINRA should provide exam scores to those who pass their qualification exams?

110 people voted: 73% answered “yes” and 27% answered “no.”

Before October 2018, everyone who took a securities exam received a score. Since October 2018, FINRA only provides a score to those who fail. But the results of the Solomon survey are clear: ignorance is not bliss. A majority of exam respondents would like to know their exam scores upon passing.

For more polls, news, and securities exam updates, follow the Solomon LinkedIn page.

Solomon Pass Probability™ Now Available for the FINRA Series 82

Everyone would like to feel confident when they take their securities exam, but how do you know if you’re ready for test day? Solomon Exam Prep can help – with Pass Probability™. Continue reading

Everyone would like to feel confident when they take their securities exam, but how do you know if you’re ready for test day? Solomon Exam Prep can help! With Pass Probability™, now available for the FINRA Series 82 exam, Solomon takes the guesswork out of deciding when to sit for your exam.

Pass Probability™ is Solomon Exam Prep’s innovative technology that measures your readiness to pass your securities exam. Once you take five practice exams in the Solomon Exam Simulator, the Pass Probability™ tool calculates the probability that you will pass your test, with a percentage out of 100.

"A securities licensing exam is hard work and high stakes. Your enemy is uncertainty. Solomon's industry-leading Pass Probability™ feature is based on the results of thousands of Solomon securities students and uses a proprietary algorithm to reduce uncertainty. So you can enter the exam room with confidence."

Jeremy Solomon

Co-founder and President of Solomon Exam Prep

Remediation Reporting

But what should you do if you take five practice exams, and the Solomon algorithm determines that you are not ready to take your exam? This is where Solomon’s brand-new feature, the Remediation Report, comes in.

The Remediation Report is an individualized report outlining how to focus your efforts BEFORE taking your exam. It provides an added level of customized study support – sent right to your email.

The Remediation Report gives you:

Summary of current study progress
Personalized recommendations on areas for growth
Study tips for the homestretch
Reminders about student support elements

In addition to the Series 82, Solomon Pass Probability™ and Remediation Reports are currently available for the following exams: SIE, Series 6, Series 7, Series 63, Series 65, Series 66, and Series 79.

Solomon Releases New Edition of Series 14 Study Guide and Exam Simulator

The Series 14 is one of the more difficult FINRA exams, so it’s a good idea to be well-prepared going into test day – Solomon Exam Prep can help! Continue reading

Do you need to know about compliance issues related to a wide range of broker-dealer activities? Do you plan to supervise others engaged in compliance activities? If you said “yes” to these questions, then you probably work for a broker-dealer and need to take the FINRA Series 14 exam. The Series 14 is one of the more difficult FINRA exams, so it’s a good idea to be well-prepared going into test day – Solomon Exam Prep can help!

Solomon is proud to announce the release of the 2nd edition of the Solomon Exam Prep Guide to the Series 14 Compliance Officer Examination. This comprehensive Solomon Study Guide is written in clear English and packed with practice questions, exercises, and visual aids for better understanding. The 2nd edition includes key updates and improvements designed to help Series 14 students prepare for their exam more effectively so that they can pass the first time.

The Solomon Series 14 Study Guide, 2^nd edition, includes:

A chapter dedicated to research reports and research analysts, with new practice questions
Expanded and revised discussion of Regulation SHO vs. OTC close-out rules
Streamlined and simplified explanation of margin accounts
Expanded and revised discussion of Regulation M stabilizing activities
New material about tax rules for gifting shares to charity
New material about stock splits for restricted stock
New material about SPACs
New material about categories of issuers, such as WKSIs and EGCs
The SEC’s March rules update regarding Regulation D and Regulation A offerings

Solomon has also updated the Series 14 Online Exam Simulator to reflect the changes made to the Study Guide. The new Series 14 Exam Simulator contains over 2,400 questions written by Solomon content experts. This massive question bank means that you will encounter new questions with each practice quiz or exam you take. Plus, each question provides a robust explanation so that you learn even more as you test yourself.

I would like to say a big thank you to Solomon for helping me pass my Series 14 exam. I took this exam the first time and missed passing by few marks. I was really sad and discouraged so reached out to Jeremy Solomon and he really took the time to talk to me and provide his guidance and advice. He also provided me with additional resources immediately to help with my second attempt. I recently passed this exam. Their study material is easy to understand and the Online Exam Simulator also has a lot of questions chapter-wise which were very helpful. Their customer service has been amazing and very responsive. Thank you Solomon. I will definitely recommend Solomon for anyone planning to take this exam.

Rachna Shah

CBRE. Beverly Hills, CA

Solomon Exam Prep is committed to providing industry-leading securities licensing materials, which are continuously kept up-to date. If you are an existing Solomon Series 14 customer, the new 2nd edition will be automatically updated in your account, free of charge.

To view samples of the Solomon Series 14 Study Guide and Exam Simulator, visit the Solomon website here.

Solomon Exam Prep Offers Powerful New AI Feature: Remediation Reporting

Learn about the Solomon Remediation Report, a new analytical feature designed to help students pass their securities licensing exams the first time. Continue reading

Solomon Exam Prep is delighted to announce an advanced analytical feature called a Remediation Report. The Solomon system analyzes a student’s five most recent practice exams and determines whether a student is ready to take his or her exam. If Solomon AI determines that a student is not ready to sit for their exam, then it creates an individual report with personalized guidance on how to remediate and prepare to pass. This custom Remediation Report is sent to the Solomon student’s email inbox.

The Solomon Remediation Report is connected to the Solomon Pass Probability tool, the industry-leading measure of a security exam prep student’s readiness to pass an exam. Solomon Pass Probability is based on thousands of student data points. Once a Solomon student has taken at least five practice exams, the Solomon Pass Probability feature is activated, and the Pass Probability metric is available in the student’s dashboard. The Solomon Remediation Report provides an additional level of customized study support by helping students focus their efforts and remediate before they sit for their exam.

Solomon Pass Probability and Remediation Reports are currently available for the following exams: SIE, Series 6, Series 7, Series 63, Series 65, Series 66, Series 79, and Series 82.

To learn about all the features of the Solomon Exam Prep learning system, watch the video overview.

Curious about the Solomon Learning System? Watch the video overview!

Watch the latest Solomon Exam Prep video for a complete look at the Solomon learning system and what it offers students and firms. Continue reading

Solomon Exam Prep has helped thousands of financial professionals pass their FINRA, NASAA, MSRB, and NFA licensing exams. Watch the video for a complete look at the Solomon learning system and what it offers students and firms.

To explore Solomon Exam Prep study materials for 21 different securities licensing exams, including the SIE and the Series 3, 6, 7, 14, 22, 24, 26, 27, 28, 50, 51, 52, 53, 54, 63, 65, 66, 79, 82, and 99, visit the Solomon website.

Simplifying After-Tax and Tax-Equivalent Yields

For many when choosing bonds the most important factor is the tax implications. Knowing the after-tax yield and tax-equivalent yield calculations is critical. Continue reading

Bonds can be nice, reliable investments. Pay some money to an issuing company or municipality, receive interest payments twice a year, and then get all of your original investment back sometime down the road. Sounds like a plan.

But which bonds are best for a specific investor? There are many factors for bond investors to consider when choosing which bond to buy, but for many the most important is the tax implications of investing in one bond instead of another. This concern is most prominent when an investor compares a corporate bond to a municipal bond. For reference, a corporate bond is one issued by a corporation or business, while a municipal bond is one issued by a state, city, or municipal agency.

Comparing the tax implications of these bonds is important because the interest payments that investors receive from municipal bonds are typically not taxed at the federal level. Conversely, interest payments on all corporate bonds are subject to federal taxation. This means that someone in the 32% tax bracket will have to give Uncle Sam 32% of his interest received from a corporate bond, while he will not give up any of his interest received from a municipal bond. Additionally, an investor does not pay state taxes on municipal bond interest if the bond is issued in the state in which the investor lives. Corporate bond interest, on the other hand, is always subject to state tax.

interest payments taxed federally
interest payments subject to state tax

interest payments not federally taxed
interest payments not taxed by state if issued in state local to investor

For these reasons, when comparing a corporate bond to a municipal bond, understanding the after-tax yield and the tax-equivalent or corporate-equivalent yield is essential. This is true both for investors and for those who will be taking many of the FINRA, NASAA, and MSRB exams. So let’s look at how to calculate those yields.

After-Tax Yield

First the after-tax yield. The after-tax yield tells you the amount of a corporate bond’s annual interest payment that an investor will take home after accounting for taxes he will be assessed on that interest. Once that amount is known, the investor can compare it to the yield he would receive from a specific municipal bond and see which potential investment would put more money in his pocket. When calculating the after-tax yield, start with the annual interest percentage (a.k.a. coupon percentage) of the corporate bond, which represents the percent of the bond’s par value that an investor receives each year in interest. For instance, a corporate bond that has a $1,000 par value and an interest rate of 8% will pay an investor $80 dollars in annual interest ($1,000 x 0.08 = $80). You then multiply the coupon percentage by 1 minus the taxes an investor will pay on the corporate bond that he will not pay on the municipal bond that he is considering.

This is where it sometimes gets tricky. What taxes will an investor not pay when investing in a municipal bond that he will pay when investing in a corporate bond? Remember that for just about all municipal bonds, investors do not pay federal tax on interest received.

The formula for after tax yield is:

After-tax yield = Corporate Bond Annual Interest Rate x
( 1 – Taxes Investor Does Not Pay By Investing in Municipal Bond)

On the other hand, an investor always pays federal taxes on interest received from a corporate bond. Additionally, an investor does not pay state taxes on interest payments from a municipal bond issued in the state in which the investor lives.

On the other hand, an investor always pays state taxes on interest received from corporate bonds. So if you see an exam question in which you need to calculate the after-tax yield of a corporate bond to compare it the yield on a municipal bond, you will always subtract the investor’s federal income tax rate from 1 in the equation. You will also subtract the investor’s state tax rate from 1 if the municipal bond is issued in the investor’s state of residence.

Seems simple, right? Here’s a question to provide context:

Marilyn is a resident of Kentucky. She is considering a bond issued by XYZ Corporation. The bond comes with a 7% annual interest rate. Marilyn is also interested in purchasing municipal bonds issued in Ohio. If Marilyn has a federal tax rate of 28% and Kentucky’s state tax rate is 4%, what is the after-tax yield on XYZ’s bond?

To answer this question, begin with the interest rate on the XYZ bond, which is 7%. Then subtract from 1 the taxes Marilyn will not pay if she invests in the municipal bond in question. She will not pay federal taxes on the municipal bond interest, so you would subtract 28%, or .28. However, because Marilyn is a resident of Kentucky and the municipal bonds she is considering are issued in Ohio, she will pay state taxes on the bond. That means you would not subtract her state tax rate (0.04) from 1. After subtracting .28 from 1 to get 0.72, you multiply that amount by the 7% coupon payment. Doing so gives you a value of 5.04 (7 x 0.72 = 5.04%). This means that the interest amount she would take home from the XYZ bond would be equivalent to what she would receive from a municipal bond issued in Ohio that has a 5.04% interest payment. If she can get a bond issued in Ohio that has a higher interest payment than 5.04%, she would take home more money in annual interest payments than she would from the XYZ bond.

Tax-Equivalent Yield

The second approach an investor can take to compare how a potential bond investment will be affected by taxation is to calculate the tax-equivalent yield (TEY). This calculation is also known as the corporate-equivalent yield (CEY). The TEY/CEY measures the yield that a corporate bond will have to pay to be equivalent to a given municipal bond after accounting for taxes due. To calculate this yield, you take the annual interest of the given municipal bond and divide it by 1 minus the taxes the investor will not pay if she invests in the municipal bond that she would pay if she invested in a corporate bond.

Here’s the formula for tax-equivalent yield:

Tax-equivalent yield = Municipal Bond Annual Interest Rate /
(1 – Taxes Investor Does Not Pay By Investing in Municipal Bond)

When determining what tax rates to subtract from 1 in the denominator, the same principal as described above applies. That is, the investor will not have to pay federal tax on the municipal bond, so her federal rate is always subtracted from 1. The investor will also not have to pay state tax on the bond if it is issued in the state in which she lives. If that is the case, the investor’s state tax rate should also be subtracted from 1. However, if the investor lives in a different state than the state in which the bond is issued, she will have to pay state taxes on the interest payments. In that case, her state tax rate would not be subtracted from 1.

Here’s another question to provide context.

Franz, a resident of Michigan, has purchased a Michigan municipal bond that pays 4% annual interest. If his federal tax bracket is 30% and the Michigan state tax rate is 4%, what interest rate would he need to receive on a corporate bond to have a comparable rate after accounting for taxes owed?

To answer this question, begin with the interest rate on the Michigan municipal bond, which is 4%. Then subtract from 1 the taxes that Franz will not pay on that bond that he would pay if he invested in a corporate bond. He wouldn’t pay federal taxes on the municipal bond interest, so you would subtract 0.30 from 1. Additionally, since the bond is issued in Michigan and he is a Michigan resident, Franz will not pay state taxes on the bond. So you subtract Michigan’s state tax rate of 4%, or 0.04, from 1 as well. After subtracting 0.30 and 0.04 from 1 to get 0.66, you divide that number into the 4% municipal bond annual interest. Doing so gives a value of 6.06 (4 / 0.66 = 6.06). This means Franz would need to find a corporate bond that pays 6.06% in annual interest to match the amount of interest he will take home annually from the Michigan municipal bond after accounting for taxes.

Many people are confused by the concepts of the after-tax and tax-equivalent yields. But you don’t have to be one of them. Just follow this simple approach and any questions you see on this topic will not be overly taxing.

Mastering these equations will help you succeed in passing the Series 6, Series 7, Series 50, Series 52, Series 65, Series 66, and Series 82.

Solomon Exam Prep SIE Practice Exam Now Available!

Meet the newest addition to Solomon Exam Prep’s lineup of free Sample Quizzes: the SIE Sample Exam! Visit the Solomon website to try it out. Continue reading

Meet the newest addition to Solomon Exam Prep’s lineup of free Sample Quizzes: the SIE Sample Exam! Like all Solomon Sample Quizzes, the SIE Sample Exam features questions from our industry-leading Online Exam Simulator. Questions are written by Solomon content experts, who are experienced in both investment education and the process of adult learning.

But unlike other Solomon Sample Quizzes, the SIE Sample Exam is a FULL exam – it contains 75 questions, just like the real FINRA SIE exam – giving you an even better idea of what the actual exam is like. You will encounter easy, medium, and difficult questions so that you can more easily gauge your current knowledge of SIE content.

All Solomon Sample Quizzes and Exams also provide instant feedback for each answer, with a full rationale to help you understand the WHY behind the what. Plus, you get a report at the end detailing your results and giving you the opportunity to review all the questions.

Visit the Solomon website here to try out the SIE Sample Exam and explore free samples of quizzes for 21 different exams.

Solomon Study Question of the Month for April

This month’s study question from the Solomon Exam Prep Online Exam Simulator question database is now available. Continue reading

This month’s study question from the Solomon Online Exam Simulator question database is now available.

*** Comment below or submit your answer to info@solomonexamprep.com to be entered to win a $20 Starbucks gift card.***

This question is relevant to the SIE and the Series 7, 14, 50, 52, and 54.

Question: A Municipal Finance Professional (MFP) hosted a $500 plate fundraiser for a governmental issuer. Does this event trigger a ban on business for two years?

A. Yes, it will trigger a ban because an MFP may not host a fundraiser.

B. Yes, it will trigger a ban because the cost per plate is above the de minimis amount.

C. No, it will not trigger a ban because the MFP did not contribute money, only time and space.

D. No, it will not trigger a ban because the MFP was holding the fundraiser, not the municipal dealer.

Correct Answer: A

Explanation: MFPs are not permitted to solicit funds for municipal issuers or their officials without triggering a two-year ban on business for their firm. Thus, holding fundraisers is not allowed. Municipal dealers are also forbidden from holding fundraisers.

To explore free samples of Solomon Exam Prep’s industry-leading online exam simulators for the SIE, Series 7, Series 14, Series 50, Series 52, Series 54, and other FINRA, MSRB, NASAA, and NFA exams, visit the Solomon website here.