What is an After-Tax Real Rate of Return?

After-Tax Real Rate of Return

The after-tax real rate of return is a measure of an investment’s performance that takes into account both the impact of taxes and the effect of inflation. It provides a more accurate picture of an investment’s true earning potential by reflecting the real purchasing power of the returns generated. The after-tax real rate of return is particularly useful when comparing different investment options, as it allows investors to make informed decisions based on the actual value of the returns they can expect to receive.

To calculate the after-tax real rate of return, follow these steps:

1. Determine the nominal return on the investment. This is the return before taking into account taxes and inflation.
2. Calculate the after-tax nominal return by subtracting the taxes paid on the investment returns from the nominal return.
3. Determine the inflation rate during the investment period.
4. Calculate the real rate of return by adjusting the after-tax nominal return for inflation using the following formula:

After-tax real rate of return = [(1 + after-tax nominal return) / (1 + inflation rate)] – 1

This formula adjusts the after-tax nominal return for inflation, providing an accurate reflection of the investment’s performance in terms of purchasing power.

Example of an After-Tax Real Rate of Return

Let’s walk through an example to calculate the after-tax real rate of return.

Assume the following:

1. You have an investment that has generated a nominal return of 10% over one year.
2. Your marginal tax rate on investment income is 25%.
3. The inflation rate during that year is 3%.

Step 1: Determine the nominal return: 10% (given)

Step 2: Calculate the after-tax nominal return: Taxes on the return = nominal return * tax rate = 10% * 25% = 2.5% After-tax nominal return = nominal return – taxes = 10% – 2.5% = 7.5%

Step 3: Determine the inflation rate: 3% (given)

Step 4: Calculate the after-tax real rate of return: After-tax real rate of return = [(1 + after-tax nominal return) / (1 + inflation rate)] – 1 After-tax real rate of return = [(1 + 0.075) / (1 + 0.03)] – 1 After-tax real rate of return = [1.075 / 1.03] – 1 After-tax real rate of return = 1.04368932 – 1 After-tax real rate of return ≈ 0.0437 or 4.37%

So, in this example, the after-tax real rate of return is approximately 4.37%. This means that after accounting for both taxes and inflation, the investment has increased your purchasing power by 4.37% over the year.