Hi all,
asking a very classic question that is causing so much confusion and hoping I’d get an answer on that.
When calculating return in the IPS, do we calculate return, gross it, then add inflation? Or is it the other way around … calculate return, add inflation, gross it. Schweser says that we should add inflation then gross it (page 9 in book #2) but past exams do the opposite.
Any guidance is appreciated.
Follow Schweser. Old past exams did it the other way round but as I understand that’s since changed (more recent past exams follow that).
Add inflation, then gross it.
You can’t exclude the effects of inflation from taxable income.
Why do I have to answer this same question year after year, and, worse, continually correct the people who answer “add inflation, then gross it” or “gross it, then add inflation”?
The answer is . . . here: http://finexamhelp123.wpengine.com/inflation-in-required-rate-of-return-to-tax-or-not-to-tax/.
In short: read the question on the exam: they’ll tell you which approach to take.
You are an inspiration to us all Magician. I will start using your website in my studies going forward!
You’re too kind.
yes, this is simply excellent!
Thank you, that’s really helpful =)
Agreed S2000 - thanks for clarifying.
You’re quite welcome.
Is the calculation of this normally required on the exam? I don’t see an LOS in the individual investor reading that states this needs to be calculated, unless I am missing something or this comes up in a later reading again? I guess it’s better to know the calculation just in case…
Take a look at the article I linked: it refers to a number of past Level III morning sessions in which the calculation was required.
It’s pretty common and quite testable, so I’d take some time and have it down. The good news is it’s a rather easy calculation. The bad news is there can sometimes be some trickiness to making sure you get to the correct income need and investable assets, and reporting your answer based on what is actually being asked for (pre-tax or post-tax / real or nominal). Practicing past exam questions is the best way to reduce potential mistakes, and you can use Bill’s list to find the relevant questions. Question 6A on the 2017 exam gives a nice example of a rather straightforward version of how they can test this.
S2000Magician, am i correct in that the non taxable account is actually a tax deferred account (TDA)?
As long at the TDA taxes you only on the withdrawals, then, yes.
That is indeed how a TDA works, as explained in the curriculum on taxes and private wealth management (Reading 9).
I also see that this inflation adjustment does not apply for a tax exempt account (TEA), which is provided your extensive collection of examples from past exams.
* provided in
S2000, can you kindly apply the logic (you explained on your link above) to 2013 AM or 2009 AM (as examples), as the official solution does neither (of the two cases) of what you have explained?
They seem to adjust PMT (Cash flow) for “after” or “before” tax
2013: It is a taxable portfolio, and withdrawals are taxed.
Investable asset = 2,500,00 + 10,000,000 (1-0.15) – 250,000 = USD 10,750,000
PMT (next year cash) = 300,000 (1+2.5%) – 125,000 (1-0.30) = USD 220,000
i/y = 220,000 / 10,750,000 = 2.05%
2009: only withdrawals are taxed.
Investable asset = 1,100,000 – 100,000 = USD 1,000,000
PMT (next year cash) = 125,000 – 80,000 (after tax) = USD 45,000 (after tax)
PMT (pre-tax cash flow) = 45,000/(1-0.20) = 56,250
i/y = 56,250 / 1,000,000 = 5.625% (pre-tax)
2015: Question #7 (b), taxable portfolio and withdrawals are taxed – although its used in a gift context but it still uses PV/FV/PMT/i/y concept.
This is the only question where they have adjusted i/y (from pre-tax to post-tax), i.e. going from 8% (pre-tax) to 6% (post-tax)
For 2013 the “nominal after-tax required rate of return for the coming year” is asked, so the problem doesn’t exist. just calculate the real after tax rate and then add (or with geometric return) inflation.