What is an After-Tax Real Rate of Return?

This refers to an investments real financial benefit after justifying the impacts of taxes and inflation. Its a more precise calculation of the net earnings of an investor after paying for income taxes and there has been an adjustment to the inflation rate. These two factors will affect the gains gotten by an investor and thus needs to be justified. This sharply contrasts an investment's gross return.

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How Does an After-Tax Real Rate of Return Work?

Within one year, the investor may earn a 12% nominal return on his own stock investment, while his actual return, the amount he pockets eventually, would be below 12%. 3% could have been the inflation for that year, dropping his actual return rate to 9% and because he profited from selling his stock, he would need to pay tax on the profits which would take extra maybe 2% off the investors return. The commission paid for buying and selling the stock reduces his return as well. Therefore, in a bid to really grow his nest eggs eventually, an investor must center on the after-tax real ROR, as against nominal return. After-tax real ROR calculates investment earnings more precisely and always varies greatly from an investment's gross (nominal) rate of return before inflation, taxes, and fees. Nevertheless, investments in securities that are inflation-protected (like TIPS), tax-favored securities (like municipal bonds), as well as, investments that are held in tax-favored accounts like Roth IRAs would reflect less difference between real rates of return after-tax and nominal returns.

Example of After-Tax Real Rate of Return?

This refers to an investments real financial benefit after justifying the impacts of taxes and inflation. Its a more precise calculation of the net earnings of an investor after paying for income taxes and there has been an adjustment to the inflation rate. These two factors will affect the gains gotten by an investor and thus needs to be justified. This sharply contrasts an investment's gross return.

This would show a more precise instance of how to determine the real rate of return after tax. In order to calculate the return, you have to ascertain the after-tax real ROR prior to inflation and its formula is, Nominal Return x (1 - tax rate). Imagine an investor who has 17% equity investments nominal return and an applicable 15% rate of tax. Then the investors after-tax real rate of return would be, 0.17 x (1 - 0.15) 14.45% or 0.1445. Assume 2.5% is inflation rate during this time. In order to determine the after tax real ROR, divide 1 + the real return after-tax by 1 + the inflation rate. Dividing by inflation shows that a dollar at hand right now is more valuable than one dollar at hand tomorrow. Thus, today's dollars have more buying power than future dollars. Based on our instance, the real ROR after-tax would be (1 + 0.1445) / (1 + 0.025)] - 1 = 1.1166 - 1 11.66% or 0.1166. Provided the real ROR is positive, then an investor would have surpassed inflation. In a situation where it is negative, then the return would not be enough to maintain an investor's standard of living years ahead. The figure is somewhat below the 17% gross return gained on the investment.