The after-tax real rate of return is the actual financial benefit of an investment after accounting for the effects of inflation and taxes. It is a more accurate measure of an investor’s net earnings after income taxes have been deducted and the rate of inflation has been considered. Both of these factors must be accounted for because they significantly impact the gains an investor ultimately receives.
Key Takeaways
- The after-tax real rate of return factors in inflation and taxes to determine the true profit or loss of an investment.
- The nominal rate of return, which only considers gross returns, stands in contrast to the after-tax real rate of return.
- Tax-advantaged investments, such as Roth IRAs and municipal bonds, will see a smaller discrepancy between nominal rates of return and after-tax rates of return.
Grasping the After-Tax Real Rate of Return
Over a year, an investor might earn a nominal rate of return of 12% on their stock investment. However, the real rate of return—the money actually received—will be less than 12%. For instance, if the inflation rate is 3%, the real rate drops to 9%. Moreover, selling the stock at a profit incurs taxes, reducing the return by another 2%, leading to an after-tax real rate of return of 7%.
Fees such as commissions to buy and sell the stock also diminish returns. Therefore, to truly grow their investments over time, investors must focus on the after-tax real rate of return, not just the nominal return.
The after-tax real rate of return is a clearer measure of investment earnings, often differing significantly from the nominal rate of return, which does not consider fees, inflation, or taxes. However, investments in tax-advantaged accounts like municipal bonds and inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS), will show less discrepancy between nominal returns and after-tax real rates of return.
Tip
The difference between the nominal return and the after-tax real rate of return is generally smaller for tax-advantaged accounts like Roth IRAs compared to other investments.
Illustration of the After-Tax Real Rate of Return
To illustrate how the after-tax real rate of return is determined, consider the following example. First, calculate the after-tax return before inflation, which is obtained as Nominal Return x (1 - tax rate). Take an investor whose nominal return on an equity investment is 17% and has an applicable tax rate of 15%. The after-tax return will be calculated as follows:
Nominal Return x (1 - tax rate) = 0.17 × (1 - 0.15) = 0.1445 = 14.45%
Now, let’s assume the inflation rate during this period is 2.5%. To calculate the real rate of return after tax, divide 1 plus the after-tax return by 1 plus the inflation rate, then subtract 1. This method reflects the reduced purchasing power of future dollars. Here’s the calculation:
((1 + 0.1445) / (1 + 0.025)) - 1 = 1.1166 - 1 = 0.1166 = 11.66%
This value is lower than the initial 17% gross return. However, as long as the real rate of return after taxes is positive, an investor will be safeguarded against inflation. If it’s negative, the return will be insufficient to maintain the investor’s standard of living.
Comparing the After-Tax Real Rate of Return and the Nominal Rate of Return
The after-tax real rate of return is determined after accounting for fees, inflation, and tax rates. In contrast, the nominal return represents the gross rate of return without considering any external factors that impact an investment’s actual performance.
Why the After-Tax Real Rate of Return is Crucial
Understanding your after-tax real rate of return provides the true benefit of an investment with considerations for fees, tax rates, and inflation. While both figures—the nominal and after-tax real rates of return—are useful tools for analyzing investment performance, a comparative analysis using the same figure for multiple investments is critical.
Example Calculation for Different Rates
Let’s calculate the after-tax real rate of return with the following parameters:
- Nominal return = 12%
- Inflation = 8.5%
- Tax rate = 15%
First, determine the after-tax return pre-inflation:
Nominal Return x (1 - tax rate) = 0.12 x (1 - 0.15) = .102 = 10.2%
Next, calculate the after-tax real rate of return:
[(1 + .102) / (1 + .085) - 1] = 1.0157 - 1 = .0157 = 1.57%
A high inflation rate can significantly impact the after-tax real rate of return, thereby emphasizing the importance of considering inflation in investment performance.
The Bottom Line
When evaluating the value of your investments, it’s crucial to consider the after-tax real rate of return, taking into account the taxes owed and the effects of inflation. This measure can help you assess if your investments will maintain your standard of living in the future.
Related Terms: Nominal Rate of Return, Gross Rate of Return, Inflation, Tax Advantaged Accounts.
