IPS - Pretax Return Calculation

CFA Level III
#1

I looked up the forum for quite a while and I still have not come up with an answer so I hope someone can clear this out for me.

Let’s say the goal is to grow the real value of the portfolio and the question is to calculate the pretax nominal return.

FV = 250,000 (inflation-adjusted), PV = -100,000, PMT (after-tax need) = 5,000, tax on withdrawal = 20%, inflation rate = 2%.

So in order to calculate the pretax nominal return, do I need to adjust for tax by calculate the pretax need ( = 5,000 / (1 - 20%)), or do I still use 5,000, and after arriving at the after-tax real return, I then divide it by (1 - 20%)? Where should i adjust for tax here?

Thanks.

#2

If all cash flow streams are on after-tax basis and you need pre-tax return rate, first calculate after tax return rate, RAT based on cash flow streams, then convert using following logic:

If RAT = RPT (1-T) then RPT = RAT/ (1-T).

The tricky is inflation rate if you have real RAT and nominal RPT is required. The guideline is first add inflation to get nominal RAT then divide by (1-T) to get nominal pre-tax return rate.

PS

I am also trying to improve my knowledge about this area and seems this is a hardly testable area.

#3

Well the tricky part you say about inflation, I think I figured it out after doing some research. Basically, if the investable assets are put in a taxable account and everything is taxed including unrealized capital gains, then inflation is also taxed, so we add inflation first and then divide by (1 - T). If the investable assets are put in a tax-deferred account and only withdrawals are taxed, then inflation is not taxed, so we divide by (1 - T) first and then add inflation. Here is an artcle by S2000 Magician about this issue: http://financialexamhelp123.com/inflation-in-required-rate-of-return-to-tax-or-not-to-tax/

About the topic I asked, I tend to agree with what you say that we calculate the after-tax real return first and then adjust for tax, but then Wiley says that it’s wrong to do so, and we must adjust the cash flow need for tax, and then calculate the return. I also heard people saying that there are questions that use the same method as Wiley’s, but I have not had the time to find and look them up. Well these IPS questions are frustrating.

#4

I solved few AM sessions and carefully was reading each guidelines. One of good things about AM, there may be few approaches in calculations of return rates what grader consider and mark positively. This does not mean that they would positively grade if we simply miss a data input as inflation rate or tax rate. So I would concentrate on such crucial details only.

#5

The tax formulas are so annoying to remember. Redoing my note cards on the section now.