What Is an After-Tax Return?
An after-tax return is any profit made on an investment after subtracting the amount due for taxes. Many businesses and high-income investors will use the after-tax return to determine their earnings. An after-tax return may be expressed nominally or as a ratio and can be used to calculate the pretax rate of return.
- An after-tax return is the profit realized on an investment after deducting taxes due.
- After-tax returns help investors determine their true earnings.
- After-tax ratios can be expressed as the difference between the market's beginning and ending values or as a ratio of after-tax tax returns to beginning market value.
- When calculating the after-tax return, it is important to only include income received and costs paid during the reporting period.
Understanding After-Tax Returns
After-tax returns break down performance data into "real-life" form for individual investors. Those investors in the highest tax bracket use municipals and high-yield stock to increase their after-tax returns. Capital gains from short-term investments due to frequent trading are subject to high tax rates.
Businesses and high tax bracket investors use after-tax returns to determine their profits. For example, say an investor paying taxes in the 30% bracket held a municipal bond that earned $100 interest. When the investor deducts the $30 tax due on income from the investment, their actual earnings are only $70.
High tax bracket investors don’t like it when their profits are bled-off in taxes. Different tax rates for gains and losses tell us that before-tax and after-tax profitability may vary widely for these investors. These investors will forego investments with higher before-tax returns in favor of investments with lower before tax returns if lower applicable tax rates result in higher after-tax returns. For this reason, investors in the highest tax brackets often prefer investments like municipal or corporate bonds or stocks that are taxed at no or lower capital tax rates.
An after-tax return can be expressed nominally as the difference between an investment’s beginning market value and ending market value plus any dividends, interest, or other income received and minus any costs or taxes paid. After-tax can be represented as the ratio of after-tax return to beginning market value, which measures the value of the investment’s after-tax profit, relative to its cost.
Requirements for After-Tax Returns
It is necessary to figure taxes correctly before they are input into the after-tax return formula. You should only include income received and costs paid during the reporting period. Also, remember that appreciation is not taxable until it is reduced to proceeds received in a sale or disposition of an underlying investment.
Determining the tax rate is by the character of the profit or loss for that item. The gains on interest and non-qualified dividends are taxed at an ordinary tax rate. Profits on sales and those from qualified dividends fall into the tax bracket of short-term or long-term capital gains tax rates.
When the inclusion of several individual items is required, multiply each item by the correct tax rate for that item. Once all individual figures are complete, add them together to arrive at a total:
- Use the top marginal federal and state tax rates for ordinary gains and losses.
- Long-term capital gains are taxed using the long-term rate.
- If applicable, include the net investment income tax (NII), alternative minimum tax (AMT), or capital loss carry-forwards offsets.