Capitalization of Income - SWL

Q: Bill is earning $50K in gross (pre-tax) income. Assuming a 5% return, how much would Bill need to replace his income indefinitely?

Use:

  • determining how much LI someone needs to replace income for loved ones

  • showing a client that the ability to earn an income is one of their greatest assets, which should be protected w/ disability insurance

  • determining how much someone would need to save for a specific income/savings goal

*The Capitalization of Income Approach replaces income on an indefinite basis

Formula:

Capitalization of Income = Required Income/Investment Return

= $50 000/0.05 = $1M

Q: If I had $1M invested @ 5%, how much would that generate each year?

= Investment Amount x Investment Return

= $1 000 000 × 0.05

= $50 000

EXAM TIP

  1. If you are NOT given a specific # of years for which you need to replace the income, calculate it indefinitely using the Capitalization of Income approach

  2. Replacing income indefinitely requires more capital

  3. If you’re replacing income for a specific # of years, you will need to use the Present Value of an Annuity formula

annuity: series of payments

Instead of being asked to replace gross income, what if you are replacing net income?

  • You need to use the net return (after-tax return)

  • net: after-tax

  • gross: before-tax

How Bill’s 5% Gross Return is Affected by Taxes

Tax Bracket

Taxes Owed to CRA

What Bill Keeps (Net Return)

40%

5% (Investment Return) x 40% (Tax Bracket) = 2%

5% (investment Return) x 60% (What Bill keeps) = 3%

Capitalization of Net Income = Required net Income/net Investment Return

= $50 000/0.03

= $1 666 666 Required Capital