After-Tax Real Rate of Return Definition

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After-Tax Real Rate of Return Definition

What Is the After-Tax Real Rate of Return?

The after-tax real rate of return is the actual financial gain of an investment after inflation and taxes are deducted. It is a more accurate representation of an investor’s net profits after paying income taxes and adjusting for inflation. Both of these elements must be considered since they have an influence on the profits received by an investment. This is in contrast to an investment’s gross rate of return and nominal rate of return.

Key Takeaways

  • The after-tax actual rate of return considers inflation and taxes to assess an investment’s genuine profit or loss.
  • The nominal rate of return, which solely considers gross returns, is the inverse of the after-tax real rate of return.
  • Tax-advantaged assets, such as Roth IRAs and municipal bonds, will have less of a difference between nominal and after-tax returns.

Understanding the After-Tax Real Rate of Return

An investor may get a nominal rate of return of 12% on his stock investment over the course of a year, but the actual rate of return, or the money he gets to keep at the end of the day, will be less than 12%. Inflation might have reached 3% for the year, reducing his actual rate of return to 9%. And, since he sold his shares at a profit, he will have to pay taxes on those earnings, which would reduce his return by another 2%, for an after-tax actual rate of return of 7%.

The fee he paid to acquire and sell the shares reduces his return as well. To really build their nest eggs over time, investors must concentrate on the after-tax real rate of return rather than the nominal rate of return.

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The after-tax real rate of return is a more realistic estimate of investment profits and often varies considerably from the nominal (gross) rate of return, or the rate of return before fees, inflation, and taxes. 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 of a difference between nominal returns and after-tax real rates of return.

Tip

The discrepancy between the nominal return and the after-tax real rate of return on tax-advantaged accounts such as Roth IRAs is unlikely to be as large as it is on other assets.

Example of the After-Tax Real Rate of Return

Let’s go a little more precise about how the after-tax actual rate of return is calculated. The return is initially computed by calculating the after-tax return before inflation, which is calculated as Nominal Return x Inflation (1 – tax rate).Consider an investor who has a nominal return on his stock investment of 17% and a tax rate of 15%. As a result, his after-tax return is: 0.17 ( 1 0.15 ) = 0.1445 = 14.45 % 0.17 \times (1 – 0.15) = 0.1445 = 14.45\% 0.17×(1−0.15)=0.1445=14.45%

Assume the inflation rate is 2.5% for this time period. To determine the after-tax real rate of return, divide 1 plus the after-tax return by 1 plus the inflation rate, then remove 1. Dividing by inflation accounts for the reality that a dollar today is worth more than a dollar tomorrow. Future monies, in other words, have less buying power than today’s dollars.

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Using our example, the after-tax actual rate of return is as follows:

(1+0.1445)(1+0.025)−1=1.1166−1=0.1166=11.66%\frac{(1 + 0.1445)}{(1 + 0.025)} – 1 = 1.1166 – 1 = 0.1166 = 11.66\% ​−1=1.1166−1=0.1166=11.66%

This value is much lower than the 17% gross return on investment. However, as long as the actual rate of return after taxes is positive, an investor will outperform inflation. If it’s negative, the return won’t be enough to keep an investor’s quality of living up in the future.

What Is the Difference Between the After-Tax Real Rate of Return and the Nominal Rate of Return?

After fees, inflation, and tax rates are taken into account, the after-tax actual rate of return is calculated. The nominal return is just the gross rate of return before any other variables that influence an investment’s actual performance are included.

Is the After-Tax Real Rate of Return Better Than the Nominal Rate of Return?

Because it considers your fees, tax rate, and inflation, your after-tax real rate of return will show you the true benefit of the investment and if it is adequate to support your level of living in the future.

Both numbers are valuable for analyzing the performance of an investment. When comparing two investments, it is critical to use the same amount for each.

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?

To get your after-tax real rate of return, first compute your after-tax pre-inflation rate of return, which is determined as Nominal Return x (1 – tax rate).That is 0.12 x (1 – 0.15) =.102 = 10.2%.

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Divide 1 plus the amount above by 1 plus the inflation rate to get the after-tax actual rate of return. After-tax actual rate of return = [(1 +.102) / (1 +.085) – 1] = 1.0157 – 1 =.0157 = 1.57% As you can see, a high inflation rate has a significant influence on your investment’s after-tax actual rate of return.

The Bottom Line

When determining the worth of your assets, consider not just the nominal rate of return but also the after-tax real rate of return, which accounts for taxes and the impact of inflation. The after-tax actual rate of return might indicate if your nest egg investments will enable you to retain your current quality of living in the future.

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