Home/Guides/Tax and after-tax return
Tax is charged on the inflation as well, and the order of operations decides the answer
Nominal gains are taxed in full, including the part that is purely inflation. Tax first and deflate second, or you will report a real return that never existed.
Tax is assessed on the whole nominal gain, including the portion that is nothing but inflation, so the correct sequence is to apply tax first and deflate second. Reverse it and you overstate the result, sometimes by enough to turn a loss into a gain. At 5% inflation, a 6% nominal return taxed at 25% leaves a real return below zero.
The subtraction everybody uses is an approximation
Real return is not nominal minus inflation. It is one plus the nominal rate, divided by one plus the inflation rate, minus one. The shortcut is close enough when both numbers are small and drifts as they grow: at 3% and 2% the error is a few hundredths of a point, and at 12% and 8% it is large enough to matter to a decision.
Use the division. It costs nothing, it is the definition rather than a linearisation of it, and it removes an argument you would otherwise have to have with yourself about when the shortcut stops being acceptable.
Tax first, then deflate
Take a 6% nominal return with 5% inflation and a 25% tax rate. Tax applies to the full 6%, because the code does not care which part of a gain was inflation, so 1.5 points go to tax and 4.5% survives. Deflate that by 5% inflation and the real after-tax return is about negative 0.5%. You paid tax and lost purchasing power in the same year, and both statements are correct.
Do it the other way round, deflating first and taxing the 1% real gain, and you get a positive number. That version is wrong, and it is the version most mental arithmetic produces, because deflating first is the order in which people naturally think about it. There is no inflation adjustment to basis in the United States federal code, so the government taxes the nominal figure and the sequence is fixed.
- Start with the nominal return.
- Subtract tax on the entire nominal gain.
- Divide the result by one plus inflation.
- Compare that number, not the headline, against alternatives.
Where this quietly reverses a decision
Cash and short-dated bills in an inflationary year are the clearest case: a visible, positive, apparently safe yield that is negative in real after-tax terms, held by someone who believes they are avoiding risk. They are not avoiding risk, they have selected a different one and stopped measuring it.
Inflation-linked Treasuries carry a related surprise. The inflation adjustment to principal is taxable in the year it accrues, even though no cash arrives until maturity, so a real yield can come with a current tax bill against income you have not received. Series I savings bonds defer that federal tax until redemption and are exempt from state and local tax, which is a different answer to the same problem. Neither instrument is broken; both are taxed on nominal amounts, which is the theme.
Quote returns to yourself the way they spend
Our position: a nominal pre-tax return is a marketing unit. It is the right number for comparing an investment against another investment on the same terms and the wrong number for any question involving your life, because your life is denominated in things whose prices moved. If a figure is going to inform a decision, put it in real after-tax terms before you look at it.
The difference is not academic. A portfolio compounding at a nominal 6% and one compounding at a real after-tax 0% look identical on a statement and describe two entirely different futures, and only one of them is the one you are in.
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