Let’s say you calculate the after-tax required rate of return to meet a portfolio’s objective (before inflation) = 4%. That 4% covers living expenses and so forth. Let’s also say that the inflation rate is 2% and the tax rate is 25%.
Inflation factor is added to pre tax return so that it ends as the “growth” part…in other words, it is unrealized capital gains and you dont realiize it and thus you dont pay tax for that.
In exam ALWAYS add inflation to PRE-TAX Real return (as in first method). NOT After tax Real Return.