After-Tax Real Rate Of Return

The rate of return on an investment represents the amount of money that investment generates on an after-tax basis. The calculation takes in the denominator the total size of the pot of money being invested, then it looks at whatever was returned in that period, usually a year. So if you invested $1,000 that went on to distribute back to you $100 in a year, and your $1,000 remained the same liquid value (i.e. you could sell it at any moment and get your grand back), then your annual rate of return would come out to 10%. But we have a few words and curveballs to add.

Let's add the word "real." The real rate of return represents the amount an investment returns after inflation. Because of the way the monetary system works, money tends to lose value over time, meaning that everything tends to get slightly more expense at a relatively steady pace. So if you had $1,000 last year and still have the same $1,000 this year, you actually have slightly less buying power, because everything you want to buy has gotten slightly more expensive.

The real rate of return takes this into account by subtracting inflation from the money earned. So if you have a rate of return of 10%, but inflation in that year was 2%, then your real rate of return is 8%. The 2% inflation is taken out of the 10% return, to leave you 8%. The stat basically tells you how much more you can buy this year compared to last year. You can buy 8% more this year after the investment than you could have bought last year before investing the money.

Now for the last chunk to come out: "after-tax." As you can probably guess, this is the amount of your investment profit that gets eaten up by taxes.

Say the capital gains taxes for you in this year was 25%. You earned $100 from your $1,000 investment. The government gets its $25 from that, leaving you $75, or a rate of return of 7.5%. Take out the inflation figure of 2%, and the after-tax real rate of return is 5.5%.