After-Tax Real Rate of Return Definition and How to Calculate It
The after-tax real rate of return is an investment’s financial advantage after inflation and taxes. It better estimates an investor’s net earnings after income taxes and inflation. Both of these factors affect investment gains and must be considered. Compare this to an investment’s gross and nominal returns.
Understanding After-Tax Real Return
An investor may get a nominal rate of 12% on his stock investment over a year, but his real rate of return, the money he gets in his pocket, will be less than 12%. Inflation may have been 3% for the year, lowering his real return to 9%. Since he sold his stock at a profit, he must pay taxes on those profits, reducing his return by 2% to 7%.
His stock purchase and sale commission reduces his return. For investors to expand their nest eggs over time, they must focus on the after-tax actual rate of return, not the nominal rate. The nominal (gross) rate of return, which excludes fees, inflation, and taxes, is less precise and frequently differs significantly from the after-tax real rate of return.
However, investments in municipal bonds, TIPS, and Roth IRAs will have less discrepancy between nominal returns and after-tax real rates of return.
After-tax real return example
Please explain how the after-tax real rate of return is calculated. First, compute the after-tax return before inflation: Nominal Return x (1 – tax rate). An example is an investor with a 17% equity return and a 15% tax rate. The after-tax return assumes a 2.5% inflation rate for the period. Divide 1 + the after-tax return by 1 + the inflation rate, then deduct 1. Today’s dollar is worth more than tomorrow when divided by inflation. Future dollars have less purchasing power than today’s.
This is much lower than the 17% gross investment return. An investor will beat inflation if the real rate of return after taxes is positive. A negative return won’t support an investor’s lifestyle in the future.
What Is the Difference Between After-Tax Real and Nominal Return?
After fees, inflation, and taxes, the after-tax real rate of return is calculated. The nominal return is the gross rate of return before outside influences affect an investment’s performance.
Is After-Tax Real Return Better Than Nominal?
Your after-tax real rate of return considers fees, tax rate, and inflation to determine the investment’s true value and if it will support your lifestyle in the future.
Both figures help examine investment performance. Using the same figure for two investments is critical. My nominal rate of return is 12%, inflation is 8.5%, and taxes are 15%.
What Is My Real After-Tax ROI?
First, compute your after-tax pre-inflation rate of return, which is Nominal Return x (1 – tax rate). 10.2% = 0.12 x (1-0.15) =.102.
Divide one plus the value above by one plus inflation to find the after-tax actual rate of return. After-tax actual rate of return = 1.57% [(1 +.102) / (1 +.085) – 1]. Thus, rising inflation significantly affects your investment’s after-tax real rate of return.
When valuing your investments, you should consider both your nominal and after-tax real rates of return, which account for taxes and inflation. The after-tax actual rate of return can inform you if your nest egg investments will support your lifestyle.
- The after-tax real rate of return accounts for inflation and taxes to calculate investment profit or loss.
- The nominal rate of return, which only considers gross returns, is opposite the after-tax real rate.
- Roth IRAs and municipal bonds have a smaller nominal-to-after-tax return gap.