What Is the After-Tax Real Rate of Return?

The after-tax real rate of return is the actual financial benefit of an investment after accounting for the effects of inflation and taxes. It is a more accurate measure of an investor’s net earnings after income taxes have been paid and the rate of inflation has been adjusted for. Both of these factors must be accounted for because they impact the gains an investor receives. This can be contrasted with the gross rate of return and the nominal rate of return of an investment.

Understanding the After-Tax Real Rate of Return

Over the course of a year, an investor might earn a nominal rate of return of 12% on his stock investment, but the real rate of return, the money he gets to put in his pocket at the end of the day, will be less than 12%. Inflation might have been 3% for the year, knocking his real rate of return down to 9%. And since he sold his stock at a profit, he will have to pay taxes on those profits, taking another, say 2%, off his return, 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, in order to truly grow their nest eggs over time, investors must focus on the after-tax real rate of return, not the nominal 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 IRAs, will show less discrepancy between nominal returns 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. The return is calculated first of all by determining the after-tax return before inflation, which is calculated as Nominal Return x (1 – tax rate). For example, consider an investor whose nominal return on his equity investment is 17% and his applicable tax rate is 15%. His after-tax return is, therefore:
$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.

What Is an A-B Trust?

An A-B trust is a joint trust created by a married couple for the purpose of minimizing estate taxes. It is formed with each spouse placing assets in the trust and naming as the final beneficiary any suitable person except the other spouse. The trust gets its name from the fact that it splits into two separate entities when one spouse dies. Trust A is the survivor’s trust and trust B is the decedent’s trust.

Understanding an A-B Trust

Estate taxes can bite deeply into a deceased person’s assets. For example, consider a married couple that has an estate worth $20 million by the time one of the spouses dies. The surviving spouse is left with the whole $20 million, which is not taxed due to the unlimited marital deduction for assets flowing from a deceased spouse to a surviving spouse.

But then, the other spouse dies, leaving the money to their children. The taxable portion of the estate (the amount that exceeds the 2022 exemption threshold of $12.06 million will be $7.94 million). This means that $7.94 million will be taxed at 40%, leaving only $4.76 million for the beneficiaries. The exemption for 2023 is $12.92 million.

To circumvent the estate from being subject to such steep taxes, many married couples set up a trust under their last will and testaments called an A-B trust. In the example above, if the couple instead had an A-B trust, the death of the first spouse would not trigger any estate taxes as a result of the lifetime exclusion; however, a sum of money equal to the current exemption amount will be transferred into an irrevocable trust called the bypass trust or B trust.

This trust is also known as the decedent’s trust. The remaining amount, $7.94 million, will be transferred to a survivor’s trust, or A trust, which the surviving spouse will have complete control over. The estate tax on the A trust is deferred until after the death of the surviving spouse.

Benefits of an A-B Trust

The A trust contains the surviving spouse’s property interests, but they have limited control over the assets in the deceased spouse’s trust; however, this limited control over the B trust will still enable the surviving spouse to live in the couple’s house and draw income from the trust, provided these terms are stipulated in the trust.

While the surviving spouse can access the bypass trust, if necessary, the assets in this trust will bypass their taxable estate after they die. After the surviving spouse dies, only the assets in the A trust are subject to estate taxes. If the estate tax exemption for this spouse is also $12.06 million for 2022 (the exemption threshold for 2023 is $12.92 million) and the value of assets in the survivor’s trust is still valued at $7.94 million, none of it will be subject to estate tax.

The federal tax exemption is transferable between married couples through a designation referred to as the portability of the estate tax exemption. If one spouse dies, the unused portion of their estate tax exemption can be transferred and added to the estate tax exemption of the surviving spouse. Upon the death of the surviving spouse, the property in the decedent’s trust passes tax-free to the beneficiaries named in this trust.

This is because the B trust uses up the estate tax exemption of the spouse that died first, hence, any funds left in the decedent’s trust will be passed tax-free. As the decedent’s trust is not considered part of the surviving spouse’s estate for purposes of the estate tax, double taxation is avoided.

Net Worth and A-B Trusts

If the deceased spouse’s estate falls under the amount of their tax exemption, then it may not be necessary to establish a survivor’s trust. The unused portion of the late spouse’s federal tax exemption can be transferred to the surviving spouse’s tax exemption by filling out IRS Form 706.

While A-B trusts are a great way to minimize estate taxes, they are not used much today. They were popular in the decades around the turn of the 21st century when the estate tax—which hadn’t been adjusted for years—could be triggered on estates as small as $1 million or $2 million. Nowadays, each individual has a combined lifetime federal gift tax and estate tax exemption of $12.06 million in 2022, rising to $12.92 million in 2023.

So only people with estates valued over $12.06 million will opt for an A-B trust in 2022. With the portability provision, a surviving spouse can include the tax exemption of their late spouse, allowing up to $24.12 million as of 2022 and $25.84 million in 2023, which can be transferred tax-free to beneficiaries.

What Does Accepting Risk Mean?

Accepting risk, or risk acceptance, occurs when a business or individual acknowledges that the potential loss from a risk is not great enough to warrant spending money to avoid it. Also known as “risk retention,” it is an aspect of risk management commonly found in the business or investment fields.

Risk acceptance posits that infrequent and small risks—ones that do not have the ability to be catastrophic or otherwise too expensive—are worth accepting with the acknowledgment that any problems will be dealt with if and when they arise. Such a trade-off is a valuable tool in the process of prioritization and budgeting.

Accepting Risk Explained

Many businesses use risk management techniques to identify, assess and prioritize risks for the purpose of minimizing, monitoring, and controlling said risks. Most businesses and risk management personnel will find that they have greater and more numerous risks than they can manage, mitigate, or avoid given the resources they are allocated. As such, businesses must find a balance between the potential costs of an issue resulting from a known risk and the expense involved in avoiding or otherwise dealing with it. Types of risks include uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters, and overly aggressive competition.

Accepting risk can be seen as a form of self-insurance. Any and all risks that are not accepted, transferred or avoided are said to be “retained.” Most examples of a business accepting a risk involve risks that are relatively small. But sometimes entities may accept a risk that would be so catastrophic that insuring against it is not feasible due to cost. In addition, any potential losses from a risk not covered by insurance or over the insured amount is an example of accepting risk.

Some Alternatives to Accepting Risk

In addition to accepting risk, there are a few ways to approach and treat risk in risk management. They include:

• Avoidance: This entails changing plans to eliminate a risk. This strategy is good for risks that could potentially have a significant impact on a business or project.
• Transfer: Applicable to projects with multiple parties. Not frequently used. Often includes insurance. Also known as “risk sharing,” insurance policies effectively shift risk from the insured to the insurer.
• Mitigation: Limiting the impact of a risk so that if a problem occurs it will be easier to fix. This is the most common. Also known as “optimizing risk” or “reduction,” hedging strategies are common forms of risk mitigation.
• Exploitation: Some risks are good, such as if a product is so popular there are not enough staff to keep up with sales. In such a case, the risk can be exploited by adding more sales staff.