Another tax individual IPS return question question

brain_wash_your

If you include taxes in your spending inflows and outflows, why do you need to adjust the return for taxes separately after adding inflation?

For example, for the 2nd Schweser practice exam vol 1 Q1 it asks for the Smith's required return next year and the answer key shows it as the "required after tax nominal return" and does not divide by (1-t).

On the same exam Q6 asks for the "required after tax nominal rate of return" and does gross up as the last step and does divide by (1-t), despite the fact that the spending is after tax.

Windjammer

There are multiple threads on this same topic. Can someone please help to clarify?

I having trouble visualizing why inflation is taxed.

canadiananalyst

mrbucy22 Wrote:
-------------------------------------------------------
> Yes. I think that is safe bet.
>
> But I do not get why on the quick sheet for the
> pre-tax return, the inflation is divided by the
> income tax rate? How is inflation connected to
> taxes?


only if inflation (aka capital gains) is taxed annually

skycfa

Yes. I think that is safe bet.

But I do not get why on the quick sheet for the pre-tax return, the inflation is divided by the income tax rate? How is inflation connected to taxes?

cityboy

I had the same question - but I think it boils down to maintaining the real value of the portfolio.

You increase your spending needs by inflation, so that your return covers that, but you still need to grow your portfolio by inflation, just so that the base doesn't lose value due to inflation. Almost every case says to maintain the portfolio's real value, and without the inflation add on it's worth less next year than it its now in real terms.

I think I've finally learned to stop going through this in my head every time, and just multiply the required return by inflation - as it's always there in the answer key.

mcmc

Any help with this one?

Iginla2011

When you account for taxes in the return calculation, you're accounting for taxes paid on investment income. Taxes applied to salary income would be adjusted for income tax.

I think you may be confused on the meaning of after-tax required return. This refers to the return the investor needs after accounting for taxes, so no need to do the 1-t adjustment. When it asks for pre-tax return, then you need to divide by 1-t. This is the return required meeting living expenses AND pay taxes on investment income.

Hope this helps.