After-Tax Real Rate of Return: Definition and How to Calculate It

What Is the After-Tax Real Rate of Return?

The after-tax real rate of return is the amount of profit that an investor earns after any taxes are paid and the impact of inflation is accounted for. Usually expressed as a percentage, this is a more accurate number than gross rate of return or nominal rate of return.

It is the "real" return on the money, or the amount that the investor actually pockets after costs.

Understanding the After-Tax Real Rate of Return

Over the course of a year, an investor might earn a nominal real rate of return of 12% on a stock investment, but the real rate of return—the money the investor pockets after selling the stock—will be less than 12%. Inflation might have been 3% for the year, knocking his real rate of return down to 9%.

And, if the stock was sold at a profit, the investor will have to pay capital gains taxes on those profits, taking more off his return, say 2%, for an after-tax real rate of return of 7%.

The commission he paid to buy and sell the stock also diminishes his return. Thus, to truly grow their nest eggs over time, investors must focus on the after-tax real rate of return, not the nominal rate of return.

The after-tax real rate of return is a more accurate measure of investment earnings and usually differs significantly from an investment’s nominal (gross) rate of return, or its return before fees, inflation, and taxes.

However, investments in tax-advantaged securities, such as municipal bonds and inflation-protected securities, such as Treasury inflation-protected securities (TIPS), as well as investments held in tax-advantaged accounts, such as Roth individual retirement accounts (Roth IRAs), will show less discrepancy between nominal rates of return and after-tax real rates of return.

Example of the After-Tax Real Rate of Return

Let’s be more specific about how the after-tax real rate of return is determined. First, the return is calculated by determining the after-tax return before inflation, which is calculated as nominal return × (1 - tax rate). For example, consider an investor whose nominal return on his equity investment is 17% and his applicable tax rate is 15%. Therefore, his after-tax return is: $0.17 \times (1 - 0.15) = 0.1445 = 14.45\%$0.17×(1−0.15)=0.1445=14.45%

Let’s assume that the inflation rate during this period is 2.5%. To calculate the real rate of return after tax, divide 1 plus the after-tax return by 1 plus the inflation rate, then subtract 1. Dividing by inflation reflects the fact that a dollar in hand today is worth more than a dollar in hand tomorrow. In other words, future dollars have less purchasing power than today’s dollars.

Following our example, the after-tax real rate of return is:

$\frac{(1 + 0.1445)}{(1 + 0.025)} - 1 = 1.1166 - 1 = 0.1166 = 11.66\%$(1+0.025)(1+0.1445)​−1=1.1166−1=0.1166=11.66%

That figure is quite a bit lower than the 17% gross return received on the investment. As long as the real rate of return after taxes is positive, however, an investor will be ahead of inflation. If it’s negative, the return will not be sufficient to sustain an investor’s standard of living in the future.

The Bottom Line

When you are assessing the value of your investments, it’s important to look at not just your nominal rate of return but also the after-tax real rate of return, which takes into account the taxes you’ll owe and inflation’s effect. The after-tax real rate of return can tell you if your nest egg investments will allow you to maintain your standard of living in the future.