In this video, we walk through 5 TCP practice questions teaching about calculating ROI for different investments. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Calculating ROI for Different Investments
Return on Investment (ROI) is a financial metric used to evaluate the efficiency and profitability of an investment. It measures the gain or loss generated relative to the amount of money invested. ROI is crucial for investors as it helps compare the profitability of different investments and make informed decisions.
The basic formula for calculating ROI is:
ROI = (Investment Balance – Cost of Investment) / Cost of Investment × 100
This formula gives the ROI as a percentage, allowing easy comparison across various investments.
ROI Calculation for Roth IRAs
Roth IRA contributions are made with after-tax dollars, meaning the contributions are taxed before they are deposited into the account. The key benefit is that qualified withdrawals during retirement are tax-free.
Without Considering Tax
When calculating ROI for a Roth IRA without considering taxes, the formula is straightforward:
- Determine Total Contributions: Multiply the annual contribution by the number of years of investment.
- Total Contributions = Annual Contribution × Number of Years
- Calculate the ROI: Use the final account balance and total contributions.
- ROI = (Final Balance – Total Contributions) / Total Contributions × 100
Example:
Linda invests $5,000 each year into a Roth IRA for 20 years. The balance at retirement is $150,000.
Total Contributions = 5,000 × 20 = 100,000
ROI = (150,000 – 100,000) / 100,000 × 100 = 50%
Considering Tax
To get a more accurate picture of the economic effort, consider the pre-tax income needed to make after-tax contributions:
- Calculate Pre-tax Income: Adjust contributions to reflect pre-tax earnings.
- Pre-tax Income = Total Contributions / (1 – Tax Rate)
- Calculate the ROI: Use the final balance and pre-tax income.
- ROI = (Final Balance – Pre-tax Income) / Pre-tax Income × 100
Example:
Assuming a 22% tax rate, Linda’s adjusted contributions:
Pre-tax Income = 100,000 / (1 – 0.22) = 128,205.13
ROI = (150,000 – 128,205.13) / 128,205.13 × 100 = 17%
ROI Calculation for 401(k)s
401(k) contributions are typically made with pre-tax dollars, meaning contributions are deducted from your salary before taxes. Withdrawals during retirement are taxed as ordinary income.
Ignoring Tax
For 401(k)s, ignoring tax during the contribution phase, the ROI calculation is similar to the Roth IRA calculation:
- Determine Total Contributions: Include both employee and employer contributions if applicable.
- Total Contributions = (Employee Contribution + Employer Match) × Number of Years
- Calculate the ROI: Use the final account balance and total contributions.
- ROI = (Final Balance – Total Contributions) / Total Contributions × 100
Example:
Tom contributes $5,000 annually with a 50% employer match over 10 years. The final balance is $100,000.
Employee Contributions = 5,000 × 10 = 50,000
ROI = (100,000 – 50,000) / 50,000 × 100 = 100%
Considering Tax
To consider tax for 401(k) accounts, adjust for taxes paid on withdrawals:
Net Balance = Final Balance × (1 – Tax Rate)
ROI = (Net Balance – Total Contributions) / Total Contributions × 100
Example:
Assuming a 25% tax rate on withdrawals from the example with Tom:
Net Balance = 100,000 × (1 – 0.25) = 75,000
ROI = (75,000 – 50,000) / 50,000 × 100 = 50%
Calculating Balance at Retirement
To calculate the balance at retirement, consider the initial investment, annual contributions, expected ROI, and number of years invested.
- Calculate Total Contributions: Multiply the annual contribution by the number of years of investment.
- Total Contributions = Annual Contribution × Number of Years
- Calculate the Balance at Retirement: Add the growth due to ROI to the total contributions.
- Balance at Retirement = Total Contributions + (Total Contributions × ROI)
Example:
Alex contributes $6,000 annually for 25 years with an expected ROI of 100%. The final balance at retirement is calculated as follows:
Total Contributions = 6,000 × 25 = 150,000
Balance at Retirement = 150,000 + (150,000 × 1.00) = 300,000
Taxes in Post-tax vs. Pre-tax Accounts
Post-tax (Roth IRA): Contributions are made with after-tax dollars, and qualified withdrawals are tax-free. This provides tax-free growth, making it ideal for investors expecting higher tax rates in retirement. However, remember that for the return on investment to reflect the full economic effort put into the investment, you need to take into consideration the taxes paid on the after-tax dollars contributed.
Pre-tax (401(k)): Contributions are made with pre-tax dollars, reducing taxable income in the contribution year. Withdrawals are taxed as ordinary income, meaning the account grows tax-deferred but not tax-free.
