Below is a question straight from the reading, my question is simply Why does the CFA solution tax the initial $1mn investment in addition to the gains? There is no information in the question to indicate whether the 1mn has any embedded gains in it, and we don’t know if the contributions were pre-tax or post-tax.
CFA Question: Finally, Chen turns his attention to Kaminski, who currently has $1 million invested
in a tax-deferred account earning 7% per year. Kaminski will sell this investment at the
end of five years, withdraw the proceeds from the sale in a lump sum, and use those
proceeds to fund the purchase of a vacation home. Kaminski asks Chen to calculate
the after-tax wealth that will be available in five years. Kaminski’s jurisdiction has a flat tax rate of 20%.
CFA Answer
The value of the assets withdrawn from the tax-deferred account is calculated
as follows:
FV = PV × (1 + R)
n × (1 − t), where R is the portfolio pretax return.
FV = $1,000,000 × (1 + 0.07)5 × (1 − 0.20).
FV = $1,122,041.38.