How after-tax returns work
By Jude Wallis
Multiply the return by one minus the tax rate. An 8 percent return taxed at 22 percent leaves 6.24 percent, so the drag is 1.76 points. Because the tax applies to the return rather than the balance, a bigger return loses more points and a flat year loses none.
After-tax return
6.24%
1.76% of drag from a 22% tax rate.
- After-tax return
- 6.24%
- Tax drag
- 1.76%
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In short
- After-tax return is the nominal return times one minus the tax rate: 8 percent at 22 percent gives 6.24 percent.
- The drag is 1.76 points, which is 22 percent of the 8 points rather than a fixed haircut.
- A 5 percent return taxed at 37 percent leaves 3.15 percent, a drag of 1.85 points on a much smaller return.
- Inside a tax-advantaged account there is no annual drag, which is the whole argument for account choice.
- Unrealised gains are untaxed until sold, so a low-turnover holding carries less drag than its headline rate suggests.
The tax lands on the return, not the pot
This is the point people miss when they picture tax as a slice off the balance. It is a slice off the growth. At a 22 percent rate on an 8 percent return, tax takes 1.76 points and leaves 6.24 percent, and in a year with no return it takes nothing.
That proportionality is why the drag looks small on paper and large over time. Every year the after-tax return compounds from a lower base than the pre-tax one would have, and the two paths separate further with each year that passes.
Which rate belongs in the box
There is no single tax rate on investment returns, so the honest input is the rate that will apply to the return you expect. Interest is usually taxed as ordinary income at your marginal tax rate. Qualified dividends and long-term gains sit on their own schedule. Short-term gains go back to ordinary rates.
A portfolio with several income types therefore has several drags running at once, and using the top rate for all of them overstates the total. How investments are taxed sorts the income types, and how capital gains tax is computed covers the realised-gain case in detail.
The account decides more than the asset often does
Two investors in the same fund can experience different after-tax returns purely because of where they hold it. In a taxable account the annual distributions are taxed as they arrive. In a tax-deferred account nothing is taxed along the way, and the tax question moves to withdrawal.
This is what asset location is about: putting the highest-drag holdings, typically those throwing off ordinary income, where the drag is neutralised. The tax-equivalent yield calculator answers the mirror-image version of the same question for tax-exempt bonds.
Comparing like with like
Once a return is on an after-tax basis it can be compared with any other after-tax return, which is exactly what a headline number cannot do. Do the same with inflation and you have a real after-tax return, which the real return calculator handles. After-tax against pre-tax return sets out when the quoted figure is still the right one, and the after-tax return calculator does the conversion. This is educational material, not financial advice.
Worked examples
8 percent taxed at 22 percent
An investment returns 8 percent and the applicable tax rate is 22 percent. What is left after tax?
- Tax takes 22 percent of the 8 points of return, which is 1.76 points.
- The after-tax return is 8 minus 1.76, so 6.24 percent.
6.24 percent after tax, with 1.76 points lost to the drag.
A smaller return at a higher rate
A bond yields 5 percent and the investor's rate on interest is 37 percent.
- Tax takes 37 percent of 5 points, which is 1.85 points.
- That leaves 3.15 percent.
3.15 percent after tax. The drag of 1.85 points is larger than the 1.76 points on the bigger return, because the rate is higher.
Common questions
Does this apply to gains I have not sold?
No. Unrealised gains are not taxed, so deferring a sale keeps the untaxed amount compounding.
Marginal or effective rate?
Marginal, because the return stacks on top of income you already have.
Does it work for dividends?
Yes, with the rate that applies to that dividend type. Qualified and ordinary dividends are taxed differently.
Is this financial advice?
No. It is educational material about converting a return into an after-tax figure.
Keep reading
This page is educational material, not financial advice. The figures come from the formula shown and assume the inputs you enter hold for the whole term. Your own rate, fees, taxes and timing will differ, so treat the output as arithmetic to check a decision against, not as a recommendation.