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 the Difference Between ...2 Views
finance a la shmoop. what's the difference between taxable and untaxable
investment returns? for starters a return refers to getting more than $1
back after you've invested that dollar. sure you can invest a dollar and get a
negative return but well nobody goes into an investment hoping to lose money. [return explained in a graphic]
other than the you know geniuses in Congress. the ultimate untaxed return is
the IRA or the 401k pension system and it's not really untaxed, it's more like a
delayed tax, because you pay the money when you take it out and that system
investors sock away modest amounts of money each year for decades not having
to pay taxes on them until after they're about 70 years old and then they
gradually withdraw money from their pension funds spending it on golf third
marriages and dentures but key note here an IRA is not untaxed it simply deferred
tax meaning that as you withdraw money from your pension you are then taxed at
your ordinary income rate. but people like doing this because we have a [income tax rate in a graphic]
progressive tax system where from like zero to ten grand the tax is almost
nothing, from ten grand to thirty grand it's low, and like over half a million
it's like really high. got it? it's progressive in quotes. there as we can
ruefully say. and yeah the IRS doesn't let you get away with anything they'll
eventually tax pretty much everything you've got that said the pension and
retirement system is a really big benefit for most Americans who are
either undisciplined about saving money for their old age or clueless about how
the system works and government you know holding their hand sometimes squeezing
it so hard it hurts helps them to not have to live in a station wagon parked [uncle sam holds hands with citizen]
outside of the storage Depot when they're old.
so those returns are taxed eventually but figuring out how good or bad your
return is revolves largely around when you decided to pay the tax. presumably in
your old age you'll earn less money than you earned when you were working that
full-time job so that tax rate will likely be a lot less when you're 75 than
it was when you were 45. all right at the other end of the wealth spectrum you
have hedge funds all right so those are an example of generally untaxed
or delayed tax investment returns. you only pay the tax way at the very end so
you don't really worry too much if you trade stocks and realize gains and have
high churn mutual funds inside of your IRA as long as it performs well at the [money in bundles]
end of your working career you'll have a bunch of dough to go spend on golf
dentures and third wives all that stuff. okay they have beautiful offices fancy
jets they cater to the wealthy people on the planet and the numbers can be very
deceiving, because every gain on a hedge fund is taxed and most people don't have
hedge funds in their IRAs. got it all right, well here's a scenario a
soon-to-be retired proctologist who's at the rear end of his career invests in a
hedge fund and this is not inside of his IRA this is just his personal investing
in the hedge fund. the manager claims he's up 50 percent this year and the
proctologist is licking his chops thinking his million box is now worth
1.5 million, but oh that is so not the case. [man thinks about the math of returns rates]
instead the hedge fund charged a fee of 2% for managing the money so take that
50% game down to 48 percent and in fairness many hedge funds quote a net
number but we're just giving you something gross here to chew on. the
hedge fund also took a 20% success fee or profit participation fee or carry,
such that the investor paid another nine point six percent in fees which then get
subtracted off the top. so we did the math there nine point six twenty percent
of that forty eight the investor now has a pre-tax return of about 38 percent in
change. still not bad but an up fifty percent year for a hedge fund is like a
top five percent all-time kind of return. if they were in fact edged meaning most
hedge funds give up much of their gains by protecting themselves in case of bomb
hits in the middle east and the market goes down a lot. that's hedged. right but
some hedge funds don't really hedge themselves and so they can have big
numbers. all right so now comes the taxes hedge funds generally realize gains [man raises hands on trading floor]
entirely in the year in which they profit. that is the 38 percent gain is
taxed entirely at the very high ordinary income rates,
so the hedge fund itself after-tax for a 50% tax bracket payer is really only
returning 19% to the investor after-tax not 50.
yikes what seemed like the monster year was really a good year .so
let's just hope our proctologist pal didn't start spending all that money he
thought he had no but really didn't, so what we got a feeling he's gonna have to
start from the bottom once again. [doctor frowns as he drives car down the road]
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