What is the pre-tax rate of return?
The pre-tax rate of return is the return on an investment that does not include the taxes the investor must pay on that return. Since individuals’ tax situations differ and different investments result in varying levels of taxation, the pre-tax rate of return is the most commonly cited measure for investments in the financial world.
The pre-tax rate of return can be contrasted with a after tax return.
Key points to remember
- The pre-tax rate of return does not take into account capital gains or dividend taxes like the after-tax rate of return.
- This is usually equal to the nominal rate of return and is the most commonly quoted or quoted return for investments.
- It allows comparisons to be made between different asset classes since different investors may be subject to different levels of taxation.
The formula for the pre-tax rate of return is
Pre-tax rate of return=1−Tax rateAfter-tax rate of return
How to calculate the pre-tax rate of return
The pre-tax rate of return is calculated as the after-tax rate of return divided by one, minus the tax rate.
What does the pre-tax rate of return tell you?
The pre-tax rate of return is the gain or loss on an investment before taking taxes into account. The government applies investment taxes on additional income from holding or selling investments.
Capital gains tax apply to securities sold for profit. Dividends received from shares and interest earned on obligations are also taxed at the end of a given year.Since stock dividends may be taxed at a different level than interest income or capital gains, for example, the pre-tax rate of return allows comparisons to be made between different asset classes. Although the pre-tax rate of return is an effective comparison tool, it is the after-tax rate of return that is most important to investors.
Example of using the pre-tax rate of return
For example, suppose an individual earns an after-tax rate of return of 4.25% on ABC shares and is subject to a capital gains tax of 15%. The pre-tax rate of return is therefore 5%, or 4.25% / (1 – 15%).
For a tax-free investment, the pre- and after-tax rates of return are the same. Suppose a municipal bondXYZ bond, i.e. tax exempt also has a pre-tax return of 4.25%. Bond XYZ would therefore have the same after-tax rate of return as stock ABC.
In this case, an investor may choose the municipal bond because of its greater degree of safety and the fact that its after-tax yield is the same as that of the more volatile stock, although the latter has a higher pre-tax return.
In many cases, the pre-tax rate of return is equal to the return rate. Consider Amazon, where owning the stock for 2018 would have generated a return of 28.4% – that’s the pre-tax return and the rate of return. Now, if an investor had calculated the after-tax rate of return for their Amazon return using a capital gains tax rate of 15%, it would be 24.14%. If we only had the tax rate and the after-tax return, we would calculate the pre-tax return with the formula 24.14% / (1 – 15%).
Pre-tax and after-tax returns
Although pre-tax rates of return are the returns most often displayed or calculated, businesses and high-income investors are still very interested in after-tax returns. This is because the tax rate can have a significant impact on their decision making of what to invest in during the period they hold the investment.
After-tax returns take into account taxes, including capital gains taxes, unlike pre-tax. The rate of return is generally not displayed as an after-tax figure as each investor’s tax situation varies.
Limitations on the use of the pre-tax rate of return
Pre-tax return is fairly easily calculated and most often what is displayed when analyzing an investment, whether it is a mutual fund, ETF, bond or of an individual action. However, this omits the fact that taxes will most likely have to be paid on any income or gain received from the investment.
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