How do I calculate an after-tax return objective for an individual investor?

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AcadiFi · Accepted Answer

The return objective for an individual is typically expressed as the nominal after-tax return needed to meet the client's spending and wealth goals, grossed up to the portfolio's pre-tax required return.

Step 1: calculate real return needed by dividing annual spending need by current investable assets.
Step 2: add expected inflation to convert real to nominal.
Step 3: if the portfolio is taxable, divide the nominal return by (1 minus marginal tax rate) to get the pre-tax required nominal return.

Example: client Anselma Ruvalcaba-Dvorak, age 58, has 2.4 million in investable assets and needs 96,000 per year in spending, net of taxes, from the portfolio. Expected inflation is 2.5 percent. Marginal tax rate is 28 percent.

Step 1: real return needed equals 96,000 divided by 2,400,000 equals 4.0 percent.
Step 2: nominal after-tax return needed equals 4.0 plus 2.5 equals 6.5 percent (using additive approximation; geometric would be 6.6 percent).
Step 3: if the entire portfolio is taxable: 6.5 percent divided by (1 minus 0.28) equals 9.03 percent pre-tax.

If the portfolio is split between taxable and tax-deferred accounts, weight the gross-up accordingly. If the spending need is already before taxes (client pays taxes separately from other income), no gross-up on that component is needed.

Always state the return objective clearly on the exam: 'Anselma requires a nominal pre-tax return of 9.03 percent to sustain her 96,000 real spending need indexed to inflation.' Show computation steps for partial credit.

How do I calculate an after-tax return objective for an individual investor?

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