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%.
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Finance: What is Aftertax Yield?8 Views
Finance a la shmoop... what is after-tax yield, well we'll presume you [Yield definition on 100 dollar bill]
know what standard yield is yeah okay so you have a stock trading for a
convenient exactly 20 bucks a share it pays a quarter a share four times a year
is a dividend or a dollar a year total in dividends its dividend yield is one
over twenty or five percent right you buy share for 20 bucks you get a dollar a
year back but you the investor pay tax on that buck a share of sweet hot
dividend love if you're a 35 percent bracketed taxpayer that is you pay 35 [35% taypay circled]
percent tax on the last dollar of your income well then you only keep 65 cents
on each dollar of dividend income that you receive and yes we note that there
is both federal and state and you know sometimes other taxes that go in here [List of taxes on sticky note]
like the Obamacare flavors or other county taxes but in total we're just
saying let's make up a story here that if you pay 35 percent tax on that buck
then your real after-tax yield is a lot less than the 5 percent the company
distributes to you, you calculate your after-tax yield by replacing that
"gross" dividend of a buck with a 65 cents of dividend that you keep [After-tax yield calculation]
after-tax in the numerator like that and then that 20 bucks you paid per share of
gently-used pacemakers dot-com stays in the denominator down there it looks like
this 65 cents divided by 20 bucks and that's 3.25 percent that
is 3.25 percent is your after-tax yield so that's as it applies [Man discussing after-tax yield to stock]
to stocks what about as it applies to bonds well in a way this calculation
matters a lot more because there's an entire industry in muni-bonds which pay
lower total rates of interest but which are generally insulated from paying [Person holding a muni-bond]
taxes so in a way muni bonds compete against fully taxable corporate bonds
for your bond investing dollar well tax rates for qualified dividends
meaning they're qualified for the various deductions from equity
investments are usually meaningfully lower than ordinary income rates so
let's look at the individual paying 35 percent marginal tax on long [Magnifying glass focuses on womans face]
term investment gains well they're likely paying something close to 50% tax
on ordinary income so we have a tale of two bonds foam depot corporation whose
bonds pay 7% and we're in the muni-city muni bonds which pay 4% which is better
the two bonds are of identical credit risk and if you're Joe hard-worker high [Hoe hammering a roof]
tax payer and supporter of government pork then which of these two bonds gives
you a better after-tax yield well if you pay 50 percent ordinary income tax then
you're 7% on that corporate is half or 3.5% after-tax that's the after-tax
yield got it and your muni bond carries no tax liability to you so the 4%
gross is the four percent net as well answer well go with the muni bond
and you two will be you know in the muni [Man discussing muni-bond after-tax yield and hat lands on his head]
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