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 percentage rate of return on an investment after deducting taxes and adjusting for inflation. It represents the actual financial benefit experienced from an investment. This approach shows less of a difference from the nominal rate of return when dealing with investments in inflation-adjusted securities, since there is no need for an inflation adjustment to the calculation of investment return.
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How to Calculate the After-Tax Real Rate of Return
To determine the after-tax real rate of return, you must complete these steps:
Calculate the nominal rate of return, which is the return you will earn prior to adjusting for inflation and taxes.
Subtract the taxes paid on your nominal return, so that you can derive the after-tax nominal return.
Adjust the after-tax nominal return for the inflation rate.
After-tax rate of return - Inflation rate = After-tax real rate of return
As an example, in a case where the after-tax rate of return is 8% and the current inflation rate is 3%, the after-tax real rate of return is 5%.
Example of the After-Tax Real Rate of Return
Here is an example of how the after-tax real rate of return can be calculated:
Initial investment and nominal return. Suppose an investor puts $10,000 into a bond that earns a nominal annual return of 8%. This means the investment grows by $800 in one year ($10,000 × 8%).
Taxes on investment gains. Assume the investor falls into a 25% tax bracket for investment income. The tax on the $800 gain is $200 ($800 × 25%). The after-tax return is therefore $600 ($800 - $200).
After-tax nominal rate of return. The after-tax nominal return percentage is: $600 ÷ $10,000 = 6%. So, after paying taxes, the investor’s effective return is 6%.
Adjusting for inflation. Suppose inflation for the year is 3%. The formula for the real rate of return (after adjusting for inflation) is: (1 + after-tax nominal return) ÷ (1 + inflation rate) − 1. Plugging in the numbers: (1.06) ÷ (1.03) − 1 = 0.0291 or 2.91%.
After considering both taxes and inflation, the after-tax real rate of return is 2.91%. This represents the actual increase in the investor’s purchasing power over the year.