IPS: Inflation Rate and Tax, shall I just add them? different, multiple, methods, return

Howd

In the AM session essays, if we see inflation rate and tax for return rate calculation, shall we add or multiple them?

There are many sample answers in Qbank using different methods.

<need a break>

Roflnadal

Tax on inflation or inflation on tax, either way will work on exam, correct?

It seems CFAI has changed the way to answer those questions. I believe one way is more conservative(ending with a higher required return) than the other.

With 95% confident interval, I have got a mismatched required return with the answer. In other words, my expected return from the first 4 points(RR) is 0...need to make up from other place.

Zestt

deriv108 Wrote:
-------------------------------------------------------
> Tax on inflation or inflation on tax, either way
> will work on exam, correct?
>
> It seems CFAI has changed the way to answer those
> questions. I believe one way is more
> conservative(ending with a higher required return)
> than the other.
>
> With 95% confident interval, I have got a
> mismatched required return with the answer. In
> other words, my expected return from the first 4
> points(RR) is 0...need to make up from other
> place.

All this in real practice is done through simulation. Makes no sense to still do return requirements like this.

ll11

> If the entire amount is not taxed every year and
> you are only withdrawing, inflation is not net of
> tax.
>

Can you clarify this by giving an example from the curriculum please?

Analyze_This

revisor Wrote:
-------------------------------------------------------
> > If the entire amount is not taxed every year
> and
> > you are only withdrawing, inflation is not net
> of
> > tax.
> >
>
> Can you clarify this by giving an example from the
> curriculum please?


"Note: Strictly speaking, the inflation rate should be adjusted upward by the porfolio's average tax rate. For ease of presentation, we have simply added 3% inflation" <-- From the text as this is an account that pays tax on a yearly basis.

Whereas in the 2009 Test an account that only the withdrawal was taxable did not need to have an adjustment. Overall, it appears as if you are going to get it right either way or at least shouldn't get it wrong.

If entire portfolio is taxed on a yearly basis the entire portfolio has to grow by inflation to keep pace with the size of withdrawal.



Edited 1 time(s). Last edit at Tuesday, May 17, 2011 at 04:50PM by Paraguay.

Colum

The answer to your question is add or multiply. Both answers are listed on the essays. Multiplicative would be mathematically more correct than additive. I will be using multiplicative.

jmh530

hellscream Wrote:
-------------------------------------------------------
> Darlia, arent they same?
> The order of adding them do not change the result,
> rite?
>
> I was wondering whether i should multiply them
> instead.

Negatory if you are taxed on entire proceeds every year inflation adjusted nominal pre-tax return is higher.

If you are not, return requirement is lower.

NakedPuts00

darlia , give two examples of this: current exam and the question# , and past exam and the question #

mik82

Inflation can be multiplicative or additive. From the texts it stated the additive approach was easier to understand on the private wealth side. If you look at the essay answers they have both multiplicative and additive as possibilities. I would use multiplicative then you don't need to remember two things between institutions and individuals.

As for taxes and inflation. If the entire proceeds of the account are taxed on a yearly basis, inflation must be multiplied net of tax.

If the entire amount is not taxed every year and you are only withdrawing, inflation is not net of tax.

There is an entire thread from last couple of years relating to this. I found it via Google when I first started studying.

i.e. Return requirement 5. Taxes 20%, Inflation 3%.

If taxed every year. [(1.05)(1.03) -1]/.8 = 10.1875
If taxed only on withdrawals. [1 + (.05/.8)](1.03) = 9.4375

I think a lot of the posts on this board relate to attempting to memorize instead of understanding the theory. The tax problems are very difficult to memorize however if you spend the time to figure out what is actually being done you can answer them quickly.



Edited 3 time(s). Last edit at Tuesday, May 17, 2011 at 10:23AM by Paraguay.

Iginla2011

Add inflation to get after tax requirement, then divide by (1-tax) to get Before tax requirement.