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 After-Tax Contribution?

An after-tax contribution is money paid into a retirement or investment account after income taxes on those earnings have already been deducted. When opening a tax-advantaged retirement account, an individual may choose to defer the income taxes owed until after retiring, if it is a traditional retirement account, or pay the income taxes in the year in which the payment is made, if it is a Roth retirement account.

Some savers, mostly those with higher incomes, may contribute after-tax income to a traditional account in addition to the maximum allowable pre-tax amount. They don’t get any immediate tax benefit. This commingling of pre-tax and post-tax money takes some careful accounting for tax purposes.

Understanding After-Tax Contributions

In order to encourage Americans to save toward their retirement years, the government offers several tax-advantaged retirement plans such as the 401(k) plan, offered by many companies to their employees, and the IRA, which anyone with earned income can open through a bank or a brokerage.

Most, but not all, people who open a retirement account can choose either of two main options:

• The traditional retirement account allows its owner to put “pre-tax” money in an investment account. That is, the money is not subject to income tax in the year it is paid in. The saver’s gross taxable income for that year is reduced by the amount of the contribution. The IRS will get its due when the account holder withdraws the money, presumably after retiring.
• The Roth account is the “after-tax” option. It allows the saver to pay in money after it is taxed. That is more of a hit to the person’s immediate take-home income. But after retirement, no further taxes are owed on the entire balance in the account. The Roth 401(k) option (referred to as a designated Roth option) is newer, and not all companies offer them to their employees. Earners above a set limit are not eligible to contribute to a Roth IRA account.

Post-Tax or Pre-Tax?

The post-tax Roth option offers the attraction of a retirement nest egg that is not subject to further taxes. It makes the most sense for those who believe they may be paying a higher tax rate in the future, either because of their expected retirement income or because they think taxes will go up.

In addition, money contributed post-tax can be withdrawn at any time without a fat IRS penalty being imposed. (The profits in the account are untouchable until the account holder is 59½.)

On the downside, the post-tax option means a smaller paycheck with every contribution into the account. The pre-tax or traditional option reduces the saver’s taxes owed for the year the contributions are made, and it is a smaller hit to current income.

The downside is, withdrawals from this type of retirement fund will be taxable income, whether it’s money that was paid in or profits the money earned.

After-Tax Contributions and Roth IRAs

A Roth IRA, by definition, is a retirement account in which the earnings grow tax-free as long as the money is held in the Roth IRA for at least five years. Contributions to a Roth are made with after-tax dollars, and as a result, they are not tax-deductible. However, you can withdraw the contributions in retirement tax-free.

Both post-tax and pre-tax retirement accounts have limits on how much can be contributed each year:

• The annual contribution limit for both Roth and traditional IRAs is $6,000 for tax year 2022 (increasing to $6,500 in 2023). Those aged 50 and over can deposit an additional catch-up contribution of $1,000.
• The contribution limit for Roth and traditional 401(k) plans is $20,500 for 2022 (increasing to $22,500 in 2023), plus $6,500 for those age 50 and above.

Early Withdrawal Tax Penalty

As noted, the money deposited in a post-tax or Roth account, but not any profits it earns, can be withdrawn at any time without penalty. The taxes have already been paid, and the IRS doesn’t care.

But if it’s a pre-tax or traditional account, any money withdrawn before age 59½ is fully taxable and subject to a hefty early withdrawal penalty.

An account holder who changes jobs can roll over the money into a similar account available at the new job without paying any taxes. The term “roll over” is meaningful. It means that the money goes straight from account to account and never gets paid into your hands. Otherwise, it can count as taxable income for that year.

Special Considerations

As noted above, there are limits to the amount of money that a saver can contribute each year to a retirement account. (Actually, you can have more than one account, or a post-tax and a pre-tax account, but the total contribution limits are the same.)

Withdrawals of after-tax contributions to a traditional IRA should not be taxed. However, the only way to make sure this does not happen is to file IRS Form 8606. Form 8606 must be filed for every year you make after-tax (non-deductible) contributions to a traditional IRA and for every subsequent year until you have used up all of your after-tax balance.

Since the funds in the account are separated into taxable and non-taxable components, figuring the tax due on the required distributions is more complicated than if the account holder had made only pre-tax contributions.

What Is After-Tax Income?

After-tax income is the net income after the deduction of all federal, state, and withholding taxes. After-tax income, also called income after taxes, represents the amount of disposable income that a consumer or firm has available to spend.

Understanding After-Tax Income

Most individual tax filers use some version of the IRS Form 1040 to calculate their taxable income, income tax due, and after-tax income. To calculate after-tax income, the deductions are subtracted from gross income. The difference is the taxable income, on which income taxes are due. After-tax income is the difference between gross income and the income tax due. 

Consider the following example: Abi Sample earns $30,000 and claims $10,000 in deductions, resulting in a taxable income of $20,000. Their federal income tax rate is 15%, making the income tax due $3,000. The after-tax income is $27,000, or the difference between gross earnings and income tax ($30,000 – $3,000 = $27,000).

Individuals can also account for state and local taxes when calculating after-tax income. When doing this, sales tax and property taxes are also excluded from gross income. Continuing with the above example, Abi Sample pays $1,000 in state income tax and $500 in municipal income tax resulting in an after-tax income of $25,500 ($27,000 – $1500 = $25,500).

Calculating After-Tax Income for Businesses

Computing after-tax income for businesses is relatively the same as for individuals. However, instead of determining gross income, enterprises begin by defining total revenues. Business expenses, as recorded on the income statement, are subtracted from total revenues producing the firm’s income. Finally, any other relevant deductions are subtracted to arrive at taxable income.

The difference between the total revenues and the business expenses and deductions is the taxable income, on which taxes will be due. The difference between the business’s income and the income tax due is the after-tax income.

After-Tax and Pretax Retirement Contributions

The terms after-tax and pretax income often refer to retirement contributions or other benefits. For example, if someone makes pretax contributions to a retirement account, those contributions are subtracted from their gross pay. After deductions are made to the gross salary amount, the employer will calculate payroll taxes.

Medicare contributions and Social Security payments are calculated on the difference after these deductions are taken from the gross salary amount. However, if the employee makes after-tax contributions to a retirement account, the employer applies taxes to the employee’s gross pay and then subtracts the retirement contributions from that amount.