What is the Nominal Rate Of Return?
The nominal rate of return is the amount of money generated by an investment before factoring in expenses such as taxes, investment fees and inflation. For example, detailed data on a mutual fund might show the fund's nominal rate of return as 10 percent but also show its return after taxes on distributions and sales of fund shares as only 7 percent. Investors must look beyond an investment's nominal rate of return to get a true idea of an investment's potential earnings.
To illustrate why investors need to look beyond an investment's nominal rate of return, consider an investor who is comparing a municipal bond with a corporate bond. Both bonds have the same nominal rate of return, but their after-tax return is markedly different. In most cases, municipal bonds are tax exempt while income from corporate bonds is subject to taxation. As a result, if the IRS taxes the corporate bond at 30 percent, its rate of return is significantly less than the rate of return on the municipal bond because it is subject to capital gains tax.
Nominal Versus After-Tax Rate of Return
As stated above, the after-tax rate of return of an investment takes the effect of taxation on the investment's returns into account. In most cases, investors pay different amounts of tax on investments based on the investment, the time the investor held it and the investor's tax bracket. As a result, two investors may face different after-tax rates of return on an investment, even if it is the same investment with the same nominal rate.
Nominal Versus Real Rate of Return
The real rate of return does not take taxation into account. Rather, it considers the effect of inflation on an investment. The simple way to calculate the real rate of return is to subtract the inflation rate from the nominal rate. For example, if an investment earns a 10 percent nominal rate of return in a year with 3 percent inflation, the real rate of return is 7 percent.
However, this is a simplified reckoning of these numbers. To calculate the precise rate of return, investors use the following equation: real rate of return = (1+ nominal rate) / (1+ inflation rate) - 1. To continue with the above example, 1 plus the nominal rate is 1.10, and 1 plus the inflation rate is 1.03. Dividing 1.10 by 1.03 yields 1.068, and when 1 is subtracted from this number, it becomes 0.068 or 6.8 percent.
Nominal Versus Effective Rate of Return
The effective rate of return includes the effects of compounding on an investment. Compounding occurs when interest amounts accumulate on top of one another. To calculate the effective rate of return, investors divide the annual interest rate or nominal rate of return by the number of compounding periods in a year. Investors then add this number to 1 and, taking the sum to the power of the number of compounding periods, they subtract 1 from the sum.
Effective Rate Of Return = (1 + i/ n) n-1