# Calculating required return. Wrong answer on Kaplan?

Pg 258 Question. 1 Tax=25% Inflation =2% Spending needs=5% What’s required rate of return? Answer in the book: Before tax money need to spend : 0.05/(1-0.25)= 6.67% To cover inflation, +2% = 8.67% Or x1.02 (geometric) = 8.8% What i think is a problem : Let’s say you invest 100 and you got 8.67\$ and deduct tax (25%=2.17\$) You have 6.53\$ left. Now you spend 5\$. Now your fund is at 101.53\$. Since inflation was 2%, your real fund value decreased! (same if you started with 8.8% return) What i think is correct answer: (1.05)(1.02)=1.071 Or 1.05+1.02=1.07 (geometric vs arithmetic is not important here) To get 7.1% before tax, you need to make 7.1/(1-.0.25)=9.46% You are taxed on nominal earnings, not on real earnings. So the Kaplan guide 's method seems incorrect. Did I find a real problem or am I the mistaken? Help would be greatly appreciated.

There have been several threads on this topic. The key is to determine whether the portfolio is held in a taxable account or not.

If the account is not taxable, then only the money you withdraw for spending is taxable, but the return to cover inflation – which will remain in the account – is not taxed; in that case, Kaplan’s calculation is correct: 8.67%.

It appears that CFA Institute’s default position – if the vignette is not specific about whether returns that remain in the account are taxed or not – is that the account is not taxable. However, I would read the vignette carefully to see if that fact is mentioned.

I agree with S2000magician.

This is the CFA’s default methodology for calc’s like this.

They will clearly say whether spending is pre or post tax. (but will generally only give a tax rate if it is post tax and therefore required in the calc).

The bottom up “back of the envelope” approach the CFA use to get these figures is crude, but unfortunately they are consistent in using that approach to get the return figures in the IPS.

That’s scary.

(Scary for you, not scary for me. When I get something right, it’s generally a fluke.)

My personal opinion is that it’s just a matter of cicumstance.

Most of the time they don’t mention a tax rate. As such, even if you know an investor is taxable, you can’t invent a tax rate and apply it because they havn’t provided you with a rate.

Correct - the exam will give it away when they tell you a tax rate - there is not need to remember tax tables

According to schweser you should always (unless specifically directed, I guess) adjust for inflation first, then taxes. there is a big post under ‘study tips’ on their website for those with a login.

On a question suggesting Kaplan may have an incorrect interpretation, then responding with how Schweser say’s it should be done…

At this stage of the game shouldn’t we be more concerned with the gospel according to the CFA curriculum?

If in doubt refer to CFA…surely?