What Is the After-Tax Real Rate of Return?
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 paid and the rate of inflation has been adjusted for. Both of these factors must be accounted for because they impact the gains an investor receives. This can be contrasted with the gross rate of return and the nominal rate of return of an investment.
- The after-tax real rate of return takes into consideration inflation and taxes to determine the true profit or loss of an investment.
- The opposite of the after-tax real rate of return is the nominal rate of return, which only looks at gross returns.
- Tax-advantaged investments, such as Roth IRAs and municipal bonds, will see less of a discrepancy between nominal rates of return and after-tax rates of return.
Understanding the After-Tax Real Rate of Return
Over the course of a year, an investor might earn a nominal rate of return of 12% on his stock investment, but the real rate of return, the money he gets to put in his pocket at the end of the day, will be less than 12%. Inflation might have been 3% for the year, knocking his real rate of return down to 9%. And since he sold his stock at a profit, he will have to pay taxes on those profits, taking another, say 2%, off his return, for an after-tax real rate of return of 7%.
The commission he paid to buy and sell the stock also diminishes his return. Thus, in order to truly grow their nest eggs over time, investors must focus on the after-tax real rate of return, not the nominal return.
The after-tax real rate of return is a more accurate measure of investment earnings and usually differs significantly from an investment's nominal (gross) rate of return, 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 inflation protected securities (TIPS), as well as investments held in tax-advantaged accounts, such as Roth IRAs, will show less discrepancy between nominal returns and after-tax real rates of return.
The difference between the nominal return and the after-tax real rate of return isn't likely to be as great on tax-advantaged accounts like Roth IRAs as it is on other investments.
Example of the After-Tax Real Rate of Return
Let’s be more specific about how the after-tax real rate of return is determined. The return is calculated first of all by determining the after-tax return before inflation, which is calculated as Nominal Return x (1 - tax rate). For example, consider an investor whose nominal return on his equity investment is 17% and his applicable tax rate is 15%. His after-tax return is, therefore: 0.17×(1−0.15)=0.1445=14.45%
Let's assume that 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. Dividing 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 after-tax real rate of return is:
That figure is quite a bit lower than the 17% gross return received on the investment. As long as the real rate of return after taxes is positive, however, an investor will be ahead of inflation. If it’s negative, the return will not be sufficient to sustain an investor’s standard of living in the future.
What Is the Difference Between the After-Tax Real Rate of Return and the Nominal Rate of Return?
The after-tax real rate of return is figured after accounting for fees, inflation, and tax rates. The nominal return is simply the gross rate of return before considering any outside factors that impact an investment's actual performance.
Is the After-Tax Real Rate of Return Better Than the Nominal Rate of Return?
Your after-tax real rate of return will give you the actual benefit of the investment and whether it is sufficient to sustain your standard of living in the future, because it takes into account your fees, tax rate, and inflation.
Both figures are useful tools to analyze an investment's performance. If you are comparing two investments, it would be important to use the same figure for both.
My Nominal Rate of Return Is 12%, Inflation is 8.5%, and My Applicable Tax Rate Is 15%. What Is My After-Tax Real Rate of Return?
Your after-tax real rate of return is calculated by, first, figuring your after-tax pre-inflation rate of return, which is calculated as Nominal Return x (1 - tax rate). That would be 0.12 x (1 - 0.15) = .102 = 10.2%
To calculate the after-tax real rate of return, divide 1 plus the figure above by 1 plus the inflation rate. That would be [(1 + .102) / (1 + .085) - 1 ] = 1.0157 - 1 = .0157 = 1.57% after-tax real rate of return. As you can see, the high inflation rate has a substantial impact on the after-tax real rate of return for your investment.
The Bottom Line
When you are assessing the value of your investments, it's important to look at not just your nominal rate of return but also the after-tax real rate of return, which takes into account the taxes you'll owe and inflation's effect. The after-tax real rate of return can tell you if your nest egg investments will allow you to maintain your standard of living in the future.