Which one is preferred by CFAI: Return = (living expenses + Inflation rate) / (1-t) Return = ((living expenses / (1-t)) + Inflation rate Based on their guideline answers for 2009 exam, it seems like CFAI recommends the second formula.
what’s a concensus? i always thought pre tax return = living exp return + inflation return
I’m not sure if this is right, but I think it depends on what kind of account (as far as taxability). In one of the questions, the account is tax-deferred (withdrawals are taxable). That is why you grossed-up the annual income to pre-tax, and used that to calculate the spending rate. You didn’t have to calculate a “pre-tax” and “after-tax” portfolio return, because portfolio growth is not taxed annually. If the account is a taxable account, then withdrawals are not taxable. It’s the growth in the account that is taxable. For these accounts, you would just use their living expenses as the spending amount, calculate the “real required after-tax rate”, add inflation for the “nominal required after-tax rate” and then gross it up for taxes.
Not sure… Check page 115 of CFAI Volume 2… They say you would have to adjust inflation by the tax rate…
my understanding is: For every occasion except a TDA: Return = (living expenses + Inflation rate) / (1-t) For a TDA: Return = ((living expenses / (1-t)) + Inflation rate
Feel free to ignore me if you disagree, but I will not be grossing up taxes. Unless I am specifically asked for a pre tax return requirement, I am just going to use the after tax numbers and state that the the required return I provided is after tax. It adds an extra step and layer of complexity that is not required. So, when it comes to whether I will be grossing up return figures to show them as pre-tax, unless I am specifically asked to I will abide the immortal words of Ricky Watters “For who, for what?”
sjuhawk Wrote: ------------------------------------------------------- > Feel free to ignore me if you disagree, but I will > not be grossing up taxes. > > Unless I am specifically asked for a pre tax > return requirement, I am just going to use the > after tax numbers and state that the the required > return I provided is after tax. It adds an extra > step and layer of complexity that is not required. > > > So, when it comes to whether I will be grossing up > return figures to show them as pre-tax, unless I > am specifically asked to I will abide the immortal > words of Ricky Watters “For who, for what?” E A G L E S EAGLES!!!
Wouldn’t the debate settle itself if you use the “geometric approach” instead of the “arithmentic approach”? After Tax Return = (1+expenses) *(1+inflation) I think that’s preferred anyways, right? Ben
Weck Wrote: ------------------------------------------------------- > I’m not sure if this is right, but I think it > depends on what kind of account (as far as > taxability). > > In one of the questions, the account is > tax-deferred (withdrawals are taxable). That is > why you grossed-up the annual income to pre-tax, > and used that to calculate the spending rate. You > didn’t have to calculate a “pre-tax” and > “after-tax” portfolio return, because portfolio > growth is not taxed annually. > > If the account is a taxable account, then > withdrawals are not taxable. It’s the growth in > the account that is taxable. For these accounts, > you would just use their living expenses as the > spending amount, calculate the “real required > after-tax rate”, add inflation for the “nominal > required after-tax rate” and then gross it up for > taxes. [Like] I wish there’s a “like” button on this forum.
Additional Complexity… If for a taxable entity or individual that incur investment management fees each year… Those would have to be grossed up for tax…
By complexity I am referring to the tax alpha, asset location, and compounding issues that I have yet to see included in an IPS question, but would be prudent to address once you broach the topic of taxes.
skillionaire Wrote: ------------------------------------------------------- > sjuhawk Wrote: > -------------------------------------------------- > ----- > > Feel free to ignore me if you disagree, but I > will > > not be grossing up taxes. > > > > Unless I am specifically asked for a pre tax > > return requirement, I am just going to use the > > after tax numbers and state that the the > required > > return I provided is after tax. It adds an > extra > > step and layer of complexity that is not > required. > > > > > > So, when it comes to whether I will be grossing > up > > return figures to show them as pre-tax, unless > I > > am specifically asked to I will abide the > immortal > > words of Ricky Watters “For who, for what?” > > E > A > G > L > E > S > > EAGLES!!! Skillionair buddy, what the f’ck is wrong with you today? too much drinking?
CharterMePls Wrote: ------------------------------------------------------- > Wouldn’t the debate settle itself if you use the > “geometric approach” instead of the “arithmentic > approach”? > > After Tax Return = (1+expenses) *(1+inflation) > > I think that’s preferred anyways, right? > > Ben This is if you are calculating after-tax return. What would you do if they are asking for a pre-tax? Do you pre-tax your expenses? or both expenses and inflation?
kurmanal Wrote: ------------------------------------------------------- > CharterMePls Wrote: > -------------------------------------------------- > ----- > > Wouldn’t the debate settle itself if you use > the > > “geometric approach” instead of the > “arithmentic > > approach”? > > > > After Tax Return = (1+expenses) *(1+inflation) > > > > I think that’s preferred anyways, right? > > > > Ben > > > This is if you are calculating after-tax return. > What would you do if they are asking for a > pre-tax? Do you pre-tax your expenses? or both > expenses and inflation? Thanks Kurmanal, This is precisely what I am asking. Do you add inflation to after-tax return before calculating pre-tax return OR you calculate pre-tax return first and then add inflation?
Sorry, may have missed your question. Assuming we’re talking about accrual taxes, you would apply it to both to preserve the “real” purchasing power after tax. (1+expenses)(1+inflation)/(1-tax) If you’re talking about taxes on withdrawals only, then only apply it to the expenses (1+expenses/(1-tax))(1+inflation) I think…
Ok, here is an example… and I am getting more and more confused here… I have $1,000,000. My current needs (expenses-income) are $50,000 a year, which grows at 3% inflation. My withdrawal tax rate is 30% How much do I need to earn on my $1,000,000 to cover my next year’s expenses AND preserve my initial assets? I would go by doing this: 50,000*1.03 = 51,500. So I need to earn a minimum of $51,500 after tax return on $1,000,000. But I will have to withdraw 73,571 (51,500/70%). So my assets will have to earn 7.36%. now this answer is not even close to 10% or 11% of pre-tax return according to your formulas above… I am so screwed…
Oh i see… I forgot to add inflation in there to PRESERVE the assets… ahhh… too much studying…
On this thought… I don’t think we should EVER use the first formula… Return = (living expenses + Inflation rate) / (1-t) EDIT: actually, we would use this formula if our returns are taxed on an annual basis… in other words, if it is not a tax-deferred account… ok, I am out…
Right kurmanal. The way I would approach your example is: I need to earn 5% after tax, which is .05/.7 = 7.14% pretax. That’s going to grow every year at 3%, so (1.0714)(1.03) = 10.35% that’s my second equation. I would apply the first equation (similar to your first equation, but geometric) only if there is an accrual tax that is charged every year on unrealized gains. This doesn’t happen in any old non tax deferred account, however. I don’t even know when it would happen in the real world though I’m sure there’s times. But I’d only use it if they explicitly say that all gains are taxed every year. Ben
okay, the question that I originally posted is simple. If we have $1M portfolio, $50K liquidity needs, 3% inflation and 30% tax rate, what is my PRETAX return requirement? Method 1: (living expenses + Inflation rate) / (1-t); (5%+3%) / 70% = 11.4% Method 2: ((living expenses / (1-t)) + Inflation rate; (5%/70%) + 3% = 10.1% Which one is the correct answer? In other words, do we add inflation to living expense before we calculate tax effect OR we calculate tax effect on living expense first and then add inflation on top of it?