Tax adjusted return: Meaning, Criticisms & Real-World Uses

What Is Tax Adjusted Return?

Tax adjusted return is a metric used in portfolio performance measurement that quantifies an investment's or portfolio's actual gain after accounting for the impact of taxes on income and capital appreciation. It provides a more realistic view of an investor's profit by considering the portion of the return that is forfeited to taxes. This metric is crucial for investors operating in taxable income accounts, as it directly reflects the net benefit received from an investment. Understanding the tax adjusted return helps investors make more informed decisions about asset allocation and investment selection, especially given varying tax treatments for different types of investment income.

History and Origin

The concept of evaluating investment returns after taxes has evolved alongside the development of income taxation itself. In the United States, a permanent federal income tax was established in 1913 with the ratification of the 16th Amendment, which allowed Congress to levy taxes on incomes from any source. Prior to this, government revenue primarily came from tariffs and excise taxes. As investment markets grew and tax laws became more sophisticated, particularly with progressive tax bracket structures, investors and financial professionals increasingly recognized the significant impact taxes could have on ultimate wealth accumulation.

Major tax legislation throughout history, such as the Revenue Act of 1964 or the Tax Reform Act of 1986, consistently reshaped the landscape of investment taxation, making the consideration of tax implications a permanent feature of prudent investment analysis. For example, the Net Investment Income Tax (NIIT), a 3.8% tax on certain investment income for higher-income individuals, estates, and trusts, was introduced in 2013 as part of the Affordable Care Act, further emphasizing the need for investors to calculate their returns on an after-tax basis.⁶, ⁷ This ongoing evolution of tax codes has solidified the necessity of analyzing tax adjusted returns.

Key Takeaways

Tax adjusted return measures an investment's performance after deducting all applicable taxes on income and capital gains.
It provides a truer picture of an investor's real profit, especially for holdings in taxable accounts.
The calculation considers different tax rates for dividends, interest income, and short-term versus long-term capital gains.
Tax efficiency strategies, such as using tax-advantaged accounts or tax-efficient investment vehicles, can significantly enhance tax adjusted returns.
Comparing investments based solely on pre-tax returns can be misleading, as higher pre-tax returns might be offset by a disproportionately larger tax burden.

Formula and Calculation

The calculation of a tax adjusted return involves subtracting the taxes paid on investment income and realized gains from the nominal (pre-tax) return. The precise formula can vary depending on the complexity of the tax considerations, but a simplified approach for a single investment might be:

\text{Tax Adjusted Return} = \text{Nominal Return} \times (1 - \text{Effective Tax Rate})

Where:

Nominal Return: The total percentage return of the investment before any taxes are deducted. This includes appreciation, dividends, and interest.
Effective Tax Rate: The weighted average tax rate applied to all components of the nominal return (e.g., ordinary income rates for interest and non-qualified dividends, long-term capital gains rates for qualified dividends and long-term capital gains). This rate depends heavily on an individual's specific marginal tax rate and the nature of the investment income.

For a more granular calculation, especially when considering different types of income:

\text{Tax Adjusted Return} = \frac{\text{Ending Value} - \text{Beginning Value} - \text{Taxes Paid}}{\text{Beginning Value}}

Where:

Taxes Paid: The sum of taxes on all investment income (interest, dividends, realized capital gains) over the period. The calculation of these taxes would consider the specific tax rates for each income type (e.g., ordinary income tax rates, long-term capital gains tax rates, and potentially the Net Investment Income Tax).

Interpreting the Tax Adjusted Return

Interpreting the tax adjusted return involves comparing it against other investment options and considering personal financial circumstances. A higher tax adjusted return indicates a more efficient use of capital from a tax perspective. For instance, if Investment A has a 10% nominal return and a 2% tax drag, while Investment B has an 8% nominal return and a 0.5% tax drag, the tax adjusted returns would be 8% and 7.5% respectively. In this scenario, Investment A still outperforms after taxes, despite its higher tax burden.

It is important to evaluate the tax adjusted return in the context of an investor's overall investment portfolio and financial goals. For example, some investments might offer tax advantages that compensate for lower nominal returns, making them attractive on a tax adjusted basis. Investors should also consider the impact of potential future tax law changes and how they might affect long-term tax adjusted returns.

Hypothetical Example

Consider an investor, Sarah, who purchased 100 shares of XYZ Corp. at a cost basis of $50 per share at the beginning of the year, totaling $5,000. Over the year, XYZ Corp. stock appreciates to $60 per share, and it pays a cash dividend of $1 per share. Sarah is in a 25% ordinary income tax bracket and a 15% long-term capital gains tax bracket for qualified dividends and long-term gains. Assume she held the stock for more than one year.

Calculate Total Nominal Return:
- Capital Appreciation: ($60 - $50) * 100 shares = $1,000
- Dividends: $1 * 100 shares = $100
- Total Nominal Gain: $1,000 (appreciation) + $100 (dividends) = $1,100
- Nominal Return Percentage: ($1,100 / $5,000) * 100% = 22%
Calculate Taxes Paid:
- Taxes on Dividends (assuming qualified): $100 * 15% = $15
- Taxes on Capital Gains (assuming realized by selling at year-end and long-term): $1,000 * 15% = $150
- Total Taxes Paid: $15 (dividends) + $150 (capital gains) = $165
Calculate Tax Adjusted Return:
- Net Gain After Taxes: $1,100 (Nominal Gain) - $165 (Taxes Paid) = $935
- Tax Adjusted Return Percentage: ($935 / $5,000) * 100% = 18.7%

In this hypothetical example, while Sarah's investment had a nominal return of 22%, her tax adjusted return was 18.7% due to the taxes levied on her dividends and capital gains. This demonstrates how a seemingly good pre-tax return can be significantly reduced once tax liabilities are considered.

Practical Applications

Tax adjusted return is a critical consideration in various aspects of financial planning and investment management:

Portfolio Construction: Investors often use tax adjusted returns to choose between different investment vehicles, such as comparing Exchange-Traded Funds (ETFs) against traditional mutual funds. ETFs are often lauded for their tax efficiency due to their unique creation and redemption mechanisms and lower portfolio turnover, which can lead to fewer taxable capital gains distributions compared to actively managed mutual funds.³, ⁴, ⁵
Asset Location Strategies: Financial advisors often recommend placing tax-inefficient assets (like bonds generating interest income taxed at ordinary rates) in tax-deferred or tax-exempt accounts, and tax-efficient assets (like growth stocks with unrealized capital gains) in taxable accounts. This strategy aims to maximize overall tax adjusted returns across an entire investment portfolio. Morningstar provides insights into crafting tax-efficient portfolios for various investor types.²
Withdrawal Strategies in Retirement: For retirees, understanding tax adjusted returns is vital when determining which accounts to draw from first (e.g., taxable brokerage accounts, traditional IRAs, or Roth IRAs) to minimize their overall tax burden throughout retirement.
Performance Benchmarking: Professional money managers may report tax adjusted returns to demonstrate their ability to manage a portfolio efficiently, not just in terms of growth but also in minimizing the tax drag on returns for their clients.

Limitations and Criticisms

While highly valuable, tax adjusted return calculations have inherent limitations. One significant challenge is the dynamic nature of tax laws and individual tax situations. Tax rates can change from year to year, and an investor's personal income level, deductions, and other financial activities can influence their effective tax rate on investment income. This means a historical tax adjusted return may not be perfectly indicative of future after-tax performance.

Furthermore, accurately calculating the tax adjusted return can be complex for a diversified investment portfolio with various types of assets and transactions. It requires meticulous tracking of each income component, its specific tax treatment, and the timing of taxable events (like the realization of capital gains). The benefit of strategies like tax-loss harvesting, which can defer or offset capital gains, adds another layer of complexity that general formulas might not fully capture. Moreover, the impact of state and local taxes, which vary widely, is often excluded from simplified tax adjusted return calculations, potentially understating the actual tax burden. Russell Investments, for instance, notes that their tax-adjusted returns do not reflect the impact of state and local taxes, emphasizing that actual after-tax returns depend heavily on an investor's specific tax situation.¹

Tax Adjusted Return vs. After-Tax Return

The terms "tax adjusted return" and "after-tax return" are often used interchangeably, and in many contexts, they refer to the same concept: the investment return remaining after all applicable taxes have been paid. Both metrics aim to provide a more accurate picture of an investor's net gain by accounting for the impact of taxation on investment income and capital gains.

However, sometimes "after-tax return" might be used more broadly to refer to any return calculation that considers taxes, while "tax adjusted return" could imply a more detailed or standardized methodology for accounting for specific tax components, such as accounting for the impact of various types of income (qualified dividends vs. non-qualified, short-term vs. long-term capital gains) and potential tax efficiencies or inefficiencies. Ultimately, both terms underscore the importance of moving beyond simple pre-tax return figures to understand the true profitability of an investment.

FAQs

What types of income are considered when calculating tax adjusted return?

When calculating a tax adjusted return, all forms of investment income are considered, including interest income from bonds or savings accounts, dividends from stocks or mutual funds, and capital gains realized from selling investments for a profit. Each type of income may be subject to different tax rates, which is factored into the calculation.

Why is tax adjusted return important for investors?

Tax adjusted return is important because it reflects the actual amount of money an investor keeps after taxes. Focusing only on pre-tax returns can be misleading, as a high nominal return might be significantly reduced by taxes, especially for investors in higher tax brackets or those holding assets that generate a lot of ordinary income. It helps in making more realistic financial projections and comparing the true performance of different investments.

Do tax-advantaged accounts affect tax adjusted return calculations?

Yes, tax-advantaged accounts significantly impact tax adjusted return calculations. Investments held within accounts like 401(k)s, IRAs, or Roth IRAs generally grow tax-deferred or tax-free, meaning taxes are either postponed until withdrawal or eliminated entirely, depending on the account type. For these accounts, the nominal return is often very close to the tax adjusted return because the "tax drag" is minimized or eliminated during the accumulation phase.

How can investors improve their tax adjusted returns?

Investors can improve their tax adjusted returns through several strategies:

Asset Location: Placing tax-inefficient investments in tax-advantaged accounts.
Tax-Efficient Investments: Choosing investments like certain Exchange-Traded Funds (ETFs) that historically generate fewer taxable distributions.
Holding Period: Holding investments for over a year to qualify for lower long-term capital gains tax rates.
Tax-Loss Harvesting: Selling investments at a loss to offset capital gains and potentially a limited amount of ordinary income.
Strategic Withdrawals: Planning withdrawals from various account types in retirement to manage tax liabilities.

Is tax adjusted return the same for all investors?

No, tax adjusted return is not the same for all investors. It is highly individualized, depending on factors such as an investor's specific marginal tax rate, overall income, filing status, the types of investments they hold, and the tax laws applicable to their jurisdiction. The same investment might yield a different tax adjusted return for two different investors due to these varying personal circumstances.