After-Tax Real Rate of Return - Explained
What is an After-Tax Real Rate of Return?
Written by Jason Gordon
Updated at September 21st, 2021
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Table of Contents
What is an After-Tax Real Rate of Return?How Does an After-Tax Real Rate of Return Work?Example of After-Tax Real Rate of Return?Academics Research on After-Tax Real Rate Of ReturnWhat 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.
Academics Research on After-Tax Real Rate Of Return
- Saving and after-tax rates of return, Friend, I., & Hasbrouck, J. (1983). Saving and after-tax rates of return. The Review of Economics and Statistics, 537-543.
- Tax policy, the rate of return, and savings, Summers, L. H. (1982). Tax policy, the rate of return, and savings.
- Towards an understanding of the real effects and costs of inflation, Fischer, S., & Modigliani, F. (1978). Towards an understanding of the real effects and costs of inflation. Review of World Economics, 114(4), 810-833. Towards an understanding of real effects and inflation costs. - We show that the traditional view that inflation does not produce appreciable real effects because of the neutrality of money is valid for an economy only whose institutions are completely inflation-proof, ie to say it is an indexed economy. But we demonstrate that the real effects are becoming more and more diffused and serious as the institutions of the economy become almost more nominal. The article examines successively the consequences of nominal government institutions (the tax system, the definition of taxable income, the accounting procedure); nominal private institutions and accounting policies (mortgage and annuity contracts, income measurement), even if inflation is, and was completely anticipated. In addition the article examines the effects of inflation not anticipated and not incorporated into existing nominal long-term contracts, and uncertain future inflation. If possible, we undertake the effort to fix the social costs of the different real effects even though it is not possible at the moment to fix all the social costs of inflation.
- Fisher's Paradox and the Theory of Interest, Carmichael, J., & Stebbing, P. W. (1983). Fisher's Paradox and the Theory of Interest. The American Economic Review, 73(4), 619-630.
- Inflation and present value of timber income after taxes, Klemperer, W. D. (1979). Inflation and present value of timber income after taxes. journal of Forestry, 77(2), 94-96. Where a guiding rate of interest fluctuates with the inflation rate but remains constant in real terms, present values of future timber income after property taxes or yield taxes tend to be independent of inflation. After capital gains taxes, however, present values decline with increases in the projected inflation rate. The decline becomes less significant with lengthening payoff periods.