After you go through the calculations of expenses / investment base, you get real return. The question asks for a nominal return. So you are provided with the inflation rate and the tax rate.
[(1 + real return) * (1 + inflation)] / (1 - tax)
[(real return) / ( 1 - tax)] * (1 + inflation)
I think I know it is number 1. Why is it this way and not calculating the before tax return and multiplying by inflation (2)?
You pay taxes on Nominal return. You dont pay taxes only on real return.
Does it make sense?
I’m not sure that y’all are talking about the same thing.
The question is usually posed this way: you need a 5% return after taxes plus you want 2% to keep up with inflation, and your tax rate is 35%; what gross return do you need?
The answer is . . . it depends. On whether the 2% is taxable or not. And that information will be given to you, explicitly, in the vignette.
I wrote an article on this; I think that it was the first article on my website: http://www.financialexamhelp123.com/inflation-in-required-rate-of-return-to-tax-or-not-to-tax/
Full disclosure: as of 4/25 I’ve installed the subscription software on my website, so there’s a charge for viewing the articles.
Except for one time in some old CFAI mock, inflation is usually (and naturally) taxable.
Yeah I agree, inflation is taxable 99.99% of the time…
In fact, it isn’t.
It depends on whether you are taxed on all returns in your account, or on only the money you withdraw.
My article has examples from nine years of CFA exams (the actual morning sessions, not mock exams), and it’s about evenly split.
If there’s one general rule, it’s: read the vignette. It will tell you whether the inflation portion (that remains in the account) is taxed or not.
I stand corrected (said the man in orthopaedic shoes)