What is the real after-tax rate of return?
The real after-tax rate of return is the real financial benefit of an investment after taking into account the effects of inflation and taxes. It is a more accurate measure of an investor’s net income after paying income tax and adjusting the inflation rate. These two factors will affect the earnings that an investor receives and must therefore be taken into account. This can be contrasted with the gross return on an investment.
The after-tax real rate of return explained
Over the course of a year, an investor could earn a nominal return of 12% on his equity investment, but his actual return, the money he can put in his pocket at the end of the day, will be less than 12% . Inflation could have been 3% for the year, dropping its real rate of return to 9%. And since he sold his stock at a profit, he will have to pay taxes on these profits, by withdrawing another, say 2%, from his yield.
The commission he paid to buy and sell the stock also lowers his return. So in order to really grow their eggs over time, investors need to focus on the real after-tax rate of return, not the nominal return.
The real after-tax rate of return is a more accurate measure of investment income and generally differs significantly from the nominal (gross) rate of return on an investment, or its return before fees, inflation, and taxes. However, investments in tax-advantaged securities (such as municipal bonds) and inflation-protected securities (such as Treasury Inflated Protected Securities or TIPS) as well as investments held in tax-advantaged accounts such as Roth IRAs will show less difference between nominal and real after-tax rates of return.
Example of real after-tax rate of return
Let’s be more specific about how the real after-tax rate of return is determined. The return is calculated by first determining the after-tax return before inflation, which is calculated as the nominal return x (1 – tax rate). For example, consider an investor with a nominal return on their equity investment of 17% and their applicable tax rate is 15%. His after-tax declaration is therefore: The
Suppose the inflation rate over this period is 2.5%. To calculate the real after-tax rate of return, divide 1 plus the after-tax return by 1 plus the inflation rate. The division by inflation reflects the fact that a dollar in hand today is worth more than a dollar in hand tomorrow. In other words, future dollars have less purchasing power than today’s dollars.
Following our example, the real after-tax rate of return is:
As long as the real after-tax rate of return is positive, the investor will be ahead of inflation. If it is negative, the return will not be enough to maintain an investor’s standard of living in the future. This figure is slightly lower than the gross return of 17% received on investment.