Real Rate Of Return

The real rate of return is the cash value of a return on an investment after taxes and inflation. You can sit and listen to a slew of numbers that describe the benefit of an investment. But the real rate of return answers the one question that everyone actually cares about: What will I end up with in cash at the end of the day?

A “rate of return” is the net income from an investment over a specific period of time. A rate of return that does not include taxes or inflation is referred to as a nominal rate. Likewise, a rate of return that does include those things in its calculation is the real rate. It is a more correct depiction of what the investor will receive. 

Other calculations might give you a bigger, more appealing rate of return on your investment. But those don’t take inflation into account. They also rarely look at what you will receive after taxes. These numbers can have an effect on whether or not an investment will be worth it for you, especially if you are comparing it against other potential investment opportunities. You could also add other factors into your calculation that take money off the top of your return’s value. 

Real Rate Of Return Formula

$$Real\: Rate\: of\: Return = \dfrac{1 + Nominal\: Rate}{1 + Inflation\: Rate} - 1$$

If you are looking at the real rate of return with only inflation accounted for, you would use the above formula.

An example of this would be if you had an original nominal rate of 1%, and then you wanted to see how a 2% inflation rate affected it. However, if you also want to account for taxes, you could do that using this formula:

$$Nominal\: Rate\: (Tax\: Adjusted) = Nominal\: Rate \times (1 - Tax\: Rate)$$

You would take the result of this formula and substitute it for the nominal rate in the first formula. For instance, let’s say you had an original nominal rate of 1%. Then, you account for taxes and you now have a nominal rate of 4%. Now, you want to account for inflation as well, so you would input that 4% rate as the nominal rate in the real rate of return formula. 

In both equations, the rates should be entered into these formulas as decimals. The results will be decimals, although this rate can be expressed as a percentage. To do this, you would simply multiply the results by 100. 

You could use these formulas to measure an investment for any period of time, but you should have all your variables match that time period. For example, if you wanted to find the real rate of return over a year, you should be using annual rates. 

Real Rate Of Return Example

Kenneth is considering putting $62,000 in a year-long investment opportunity and wants to know the real rate of return on her money. She wants to account for both inflation and tax rates. The investment has a return rate of 12% and a tax rate of 4%. There will also be a 2% inflation rate during that time. 

First, we need to account for taxes. Let’s break it down to identify the meaning and value of the different variables in this problem. 

  • Original nominal rate: 12% or 0.12
  • Tax rate: 4% or 0.04

$$Nominal\: Rate\: (Tax\: Adjusted) = 0.12 \times (1 - 0.04) = 0.1152$$

Your nominal rate, after being adjusted for taxes, would be 0.1152 

With this, we can calculate the real rate of return with the remaining variables in the formula:

  • Nominal rate (tax-adjusted): 11.52% or 0.1152
  • Inflation rate: 2% or 0.02

Finally, we can apply the values to our variables and calculate the real rate of return:

$$Real\: Rate\: of\: Return = \dfrac{1 + 0.1152}{1 + 0.02} - 1 = 9.33\%$$

In this case, Kenneth’s investment would have a real rate of return of 0.09333 or 9.333%. 

Using this formula, Kenneth now has a better perspective on what he will actually get as a rate of return for his investment. That original 12% might be appealing, but in actuality, he will get closer to 9%. He would want to look at other accounts or investments to see if there is one that gives him a better ultimate return and more cash-in-hand. 

Real Rate Of Return Analysis 

The real rate of return is a much more accurate evaluation of an investment’s success over time. If your real rate of return is positive, it means your investment is still making you money beyond these additional fees and costs. However, if you wind up with a negative real rate of return, you would be losing money because of the interest and taxes your investment is incurring. 

You might be thinking that taxes and inflation affect everyone, so why does this calculation matter? Can it really make a difference across various investments? Yes, it can. In fact, some accounts are less affected by taxes over time.

A great example of this is a Roth IRA. In this, you would have paid taxes on the money you’re using to invest, but there is no tax when you withdraw the money during your retirement. You are able to grow your investment without it being affected by taxes. So, you could compare an account like this with the real rate of return on an account that is subject to taxes to learn which investment is better in the long-run.   

Real Rate Of Return Conclusion

  • The real rate of return is the cash value of your investment over time, accounting for inflation and taxes. 
  • A nominal rate is the original rate of return while the real rate includes taxes, inflation, or other factors. 
  • If you are just focusing on inflation, the real rate of return formula requires two variables: the original Nominal Rate and the Tax Rate. 
  • If you are examining inflation and taxes rates, the formula requires two additional variables: Nominal Rate and Inflation Rate
  • While the result can be expressed as a percentage, the rates should be entered into the formulas as decimals. 

Real Rate Of Return Calculator

You can use the real rate of return calculator below to learn the actual cash value of your money over time with inflation and taxes by entering the required numbers.

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