Pretax Rate of Return: Definition & Formula
One of the most crucial factors to take into account when contrasting mutual funds, exchange-traded funds, or any other sort of investment is its pretax rate of return. The percentage of income that was either lost or made within a specific time period, excluding the effect of taxes, is known as the pretax rate of return.
Although most funds will provide you with this information, it is always a good idea to know how to make the calculations yourself so that you can verify their accuracy.
Read on as we take you through exactly what the pretax rate of return is, how to calculate it, its limitations, and give you some examples of the pretax rate of return in action.
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- The pretax rate of return relates to the total return of an investment without including taxes to get paid.
- The pretax rate of return doesn’t consider dividend taxes or capital gains like the after-tax rate of return does.
- The pretax rate of return is the common rate cited by investors throughout the financial world.
- Calculating the pretax rate of return helps compare various asset classes. This can be useful information since investors are often subject to different taxation levels.
What Is the Pretax Rate of Return?
The pretax rate of return is the total return you would receive from a specific investment and doesn’t include the taxes that must get paid. The pretax rate of return is a common financial metric used throughout the financial industry.
This is because tax situations for every individual are going to vary. This can include varying levels of taxation, for example. The pretax rate of return works in the opposite way of an after-tax return.
Pretax Rate of Return Formula and How to Calculate It
Calculating the pretax rate of return is fairly simple to do. All you need to know is the after-tax rate of return and the applicable tax rate. To calculate, simply divide the after-tax rate of return by 1 minus the tax rate.
The formula to calculate the pretax rate of return would look like this:
Pretax Rate of Return Limitations
Typically, the pretax rate of return is easy to calculate and it can provide incredibly valuable information for investors to analyze. They can gain insights into an ETF, bond, mutual fund, or even an individual stock.
However, the pretax rate of return doesn’t take into account or highlight that taxes are going to need to get paid. These taxes are paid on any gains or earnings that you end up receiving in return for your investment.
Difference Between Pretax and After-Tax Returns
While the pretax rate of return is often one of the most commonly used calculations by investors, after-tax returns also provide valuable information. This is because the tax rate of after-tax returns can impact decisions. For example, it might determine how long they hold the investment. The pretax rate of return also doesn’t take into account capital gains taxes, which after-tax returns do.
Pretax Rate of Return Example
Let’s say that an investor sees an after-tax rate of return of 4.25% for an investment in Company C. The earnings are then subject to a 15% capital gains tax. So, using the formula outlined above, you can determine that the pretax rate of return is 5%.
The pretax rate of return and the after-tax rate of return is the same for tax-free investments. In this case, a municipal bond that’s tax-exempt would have the same after-tax return that Company C saw.
When this happens, investors often choose a municipal bond because it holds a higher level of safety. Plus, the after-tax return is the same as the other stock even though it had a higher pretax rate of return.
Investors and analysts are always looking to find as much information as possible for potential investments. Calculating the pretax rate of return can be helpful for investors to compare various investments across different asset classes.
Calculating the pretax rate of return is simple to do. All you need to know is the after-tax rate of return and the appropriate tax rate. From here, you simply divide the after-tax rate of return by 1 minus the tax rate. It’s also worth highlighting again that only after-tax returns take into account capital gains taxes, the pretax rate of return does not.
FAQs About Pretax Rate of Return
Pretax relates to any money taken from an individual’s gross pay before taxes get withheld.
Pretax return on equity is the pre-tax income a company reports on a consolidated basis. These get reported on the company’s financial statements.
To calculate the pretax on an investment, you simply divide the after-tax rate of return by one minus the tax rate.
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