Undersand Tax and your Investment Returns

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Taxes are paid on these investment returns, whether as the result of true market growth or inflation. While the nominal rate of return may appear impressive, part of the return goes to the government in the form of taxes and part is eroded by inflation. Both of these influences can be taken into account to disclose the real rate of return.

1. Real rate of return
a) Real Rate of Return(I1)=(I- inflation rate)/1+ inflation rate
b) Income tax adjust return(I2)= I(1-MTR)
c) After-tax, real rate of return
After tax real rate of return=[I(1-MTR)- inflation rate]/1+ inflation rate
Where I= the nominal rate of return
I1=real return
i2=after-tax return
MTR= marginal tax rate

2. Break even rate
If the real return is 0 or negative position which means that the investment is losing its purchasing power. The rate of return at which the principal amount retains its purchasing power is called the break even rate and is calculated by the formula below
break even rate=Inflation rate/ (1- MTR)
Therefore, The assumptions that investments that offer safety of principal are risk free are not quite true. Since these investments offer a low rate of return, they are exposed to inflation risk.

3. Risk and return rate
Risk and return operate on a “teeter-totter evaluation. As the return potential increase, the chance of risk is also increase Generally, investments that offer safety of principal also offer low rates of return. Since the low rates of return are subject to inflation, the result may be a negative real rate of after-tax return.

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