What Is the Pretax Rate of Return?
The pretax rate of return is the return on an investment that does not include the taxes the investor must pay on this return. Because individuals' tax situations differ and different investments attract varying levels of taxation, the pretax rate of return is the measure most commonly cited for investments in the financial world.
The pretax rate of return can be contrasted with an after-tax return.
- The pretax rate of return does not take into account capital gains or dividend taxes like the after-tax rate of return.
- This is usually equal to the nominal rate of return and is the return most often quoted or cited for investments.
- It enables comparisons to be made across different asset classes since different investors may be subject to different levels of taxation.
The Formula for the Pretax Rate of Return Is
Pretax Rate of Return=1−Tax RateAfter-Tax Rate of Return
The pretax rate of return is calculated as the after-tax rate of return divided by one, minus the tax rate.
What Does the Pretax Rate of Return Tell You?
The pretax rate of return is the gain or loss on an investment before taxes are taken into account. The government applies investment taxes on additional income earned from holding or selling investments.
Since dividends on stocks may be taxed at a different level from interest income or capital gains, for example, the pretax rate of return enables comparisons to be made across different asset classes. While the pretax rate of return is an effective comparison tool, it is the after-tax rate return that is most important to investors.
Example of How to Use the Pretax Rate of Return
For example, assume an individual achieves a 4.25% after-tax rate of return for stock ABC and is subject to a capital gains tax of 15%. The pretax rate of return is therefore 5%, or 4.25% / (1 - 15%).
For a tax-free investment, the pretax and after-tax rates of return are the same. Suppose that a municipal bond, bond XYZ, that is tax-exempt also has a pretax return of 4.25%. Bond XYZ, therefore, would have the same after-tax rate of return as stock ABC.
In this case, an investor may choose the municipal bond because of its greater degree of safety and the fact that its after-tax return is the same as that of the more volatile stock, despite the latter having a higher pretax rate of return.
Pretax vs. After-Tax Returns
While pretax rates of return are the returns most often displayed or calculated, businesses and high-income investors are still very interested in after-tax returns. This comes as the tax rate can have a meaningful impact on their decision-making—from what to invest in during the timeframe they hold the investment for.
After-tax returns take into account taxes—notably, capital gains taxes—while pretax does not. The rate of return usually isn’t displayed as an after-tax figure given the fact that each investor’s tax situation will vary.
What Are Other Terms for the Per-Tax Return?
What Are Limitations of Using the Pretax Rate of Return
The pretax return is fairly easily calculated and most often what’s displayed when analyzing an investment—whether it be a mutual fund, ETF, bond, or individual stock. However, it does leave out the fact that taxes most likely will need to be paid on any earnings or gains received as part of the investment.
At Which Rate Are Investment Returns Taxed?
Positive investment returns are taxed as capital gains. Short-term gains are imposed on positions held for less than one year, and are taxed at your marginal income tax rate. Long-term gains, for assets held longer than one year, are taxed more favorably, at either 0%, 15%, or 20% depending on your taxable income and filing status.