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 will impact the gains an investor receives, and so must be accounted for. This can be contrasted with the gross return of an investment.
The After-Tax Real Rate of Return Explained
Over the course of a year, an investor might earn a nominal return of 12% on his stock investment, but his real 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.
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 Inflated Protected Securities, or 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.
Example of the After-Tax Real Rate of Return
Let’s be more specific on how the after-tax real rate of return is determined. The return is calculated by, first of all, 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 x (1 - 0.15) = 0.1445, or 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. Dividing by inflation reflects the fact 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 [(1 + 0.1445) / (1 + 0.025)] - 1 = 1.1166 - 1 = 0.1166, or 11.66%. As long as the real rate of return after taxes is positive, 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. That figure is quite a bit lower than the 17% gross return received on the investment.