What Is the Pretax Rate of Return?
The pretax rate of return is the return on an investment before taxes. Because people’s tax circumstances varies and various assets attract different levels of taxes, the pretax rate of return is the most generally mentioned metric for financial investments.
The pretax rate of return may be compared to the after-tax rate of return.
- The pretax rate of return, unlike the after-tax rate of return, does not account for capital gains or dividend taxes.
- This is often equal to the nominal rate of return and is the most commonly mentioned or referenced return for investments.
- It allows for comparisons across asset classes since different investors may be subject to varying amounts of taxes.
The Formula for the Pretax Rate of Return Is
PretaxRateofReturn = After-TaxRateofReturn 1 TaxRatebeganaligned &textPretax Rate of Return = frac textAfter-Tax Rate of Return 1 – textTax Rate aligned at the end
The pretax rate of return is computed by dividing the after-tax rate of return by one and subtracting the tax rate.
What Does the Pretax Rate of Return Tell You?
The pretax rate of return is the profit or loss on an investment before taxes are deducted. Investment taxes are levied by the government on extra revenue obtained from owning or selling assets.
Capital gains taxes are levied on securities that are sold for a profit. Dividends from stocks and interest on bonds are also taxed at the end of the year.
Because dividends on stocks may be taxed differently than interest income or capital gains, for example, the pretax rate of return allows for comparisons across asset classes. While the pretax rate of return is a useful comparative tool, investors are more concerned with the after-tax rate of return.
Example of How to Use the Pretax Rate of Return
Assume a person earns a 4.25% after-tax rate of return on stock ABC and is subject to a 15% capital gains tax. Thus, the pretax rate of return is 5%, or 4.25% / (1 – 15%).
The pretax and after-tax rates of return for a tax-free investment are the same. Assume that a tax-exempt municipal bond, bond XYZ, provides a pretax return of 4.25%. As a result, bond XYZ would have the same after-tax rate of return as stock ABC.
In this situation, an investor may choose the municipal bond due to its better level of safety and the fact that its after-tax return is the same as that of the more volatile stock, despite the latter’s higher pretax rate of return.
Pretax vs. After-Tax Returns
While pretax rates of return are the most often stated or computed, after-tax returns are still highly important to companies and high-income investors. This is because the tax rate may have a significant influence on their decision-making, from what to invest in to how long they retain the investment.
After-tax returns include taxes, most notably capital gains taxes, but pretax returns do not. Because each investor’s tax status differs, the rate of return is typically not provided as an after-tax number.
What Are Other Terms for the Per-Tax Return?
The gross return or nominal return may also be used to calculate the pre-tax return. However, such language excludes not just taxes, but also any other expenses that may affect one’s net return, such as interest, transaction charges, commissions, and fees, among others.
What Are Limitations of Using the Pretax Rate of Return
The pretax return is very simple to compute and is often provided when examining an investment, whether it is a mutual fund, ETF, bond, or individual stock. It does, however, overlook the reality that taxes would very certainly be due on any profits or gains realized as a result of the investment.
At Which Rate Are Investment Returns Taxed?
Capital gains are taxed on positive investment returns. Short-term gains on positions held for less than a year are taxed at your marginal income tax rate. Long-term gains on assets held for more than a year are taxed more favorably, with rates ranging from 0% to 15% to 20% depending on your taxable income and filing status.
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