When measuring investment performance, it’s helpful to understand its real return. The real return on investment is what you earn after returns are adjusted for inflation and taxes. Nominal returns, on the other hand, don’t account for those deductions. Understanding the real return on investment matters, as it can tell you more accurately how much purchasing power it’s likely to yield.
You can talk to a financial advisor about how to create a strategic investment plan.
How Is Real Return Calculated?
Finding an investment’s real rate of return involves a fairly simple formula. Here’s an example:
Real return = (1+ Nominal rate) / (1 + Inflation rate) – 1
To find the real rate of return on investment, you need to know the nominal rate and the inflation rate. The nominal rate is the stated interest rate or return that you can expect to earn on an investment. The inflation rate measures changes to the prices of consumer goods and services over time.
As a general rule of thumb, nominal rates are always higher than real return rates. That makes sense since the nominal rate doesn’t account for inflation or taxes. The nominal rate and the real rate of return may align more closely when inflation is close to or at zero, or the economy is experiencing a period of deflation, both of which are rarities.
Real Return Example
It’s easy to gauge the effects of real return, even if you’re not doing a step-by-step calculation. For example, let’s say that you deposit $20,000 into a CD. The bank is offering a 5% APY, which represents the nominal rate you could earn on your money. Over a 12-month period, you’d earn $1,000 in interest.
But what if the inflation rate is 2.5%? That cuts the purchasing power of the $1,000 in interest you earned in half. So now, that money is technically worth $500, which represents your real return.
That just accounts for the impact of inflation on your CD earnings. CD interest is considered taxable income by the internal revenue service (IRS), along with interest earned on other types of savings accounts. Once you factor in what you might owe in taxes on the interest, that can shrink your real return even further.
Are There Any Flaws With Real Return?
Calculating the real rate of return requires you to factor in taxes and inflation. That’s a good thing, as again, it can give you a more realistic picture of how much spending power a particular investment is generating.
There is, however, one thing that real return doesn’t account for. This formula doesn’t incorporate the fees you might pay to own an investment, and that can include:
- Commission fees
- Fees paid to brokers
- Annual expense ratios
Managing investment fees is important as those additional costs can detract from the total returns that you get to keep. Choosing tax-efficient investments, such as low-cost index funds or exchange-traded funds (ETFs) with a low asset turnover ratio, can help to minimize your fee expenses.
It’s also important to keep in mind that every investor’s tax situation is different and that inflation is not static. Even small changes to the tax code or slight increases in prices for consumer goods and services can have a significant impact on real return calculations.
How to Maximize Real Return
Getting the most return possible for your money is challenging, as certain factors may be outside of your control. While there are things you can do to pay less in fees for your investments, there’s not a whole lot that you can do directly to control inflation or changes to the tax code.
What you can manage is how you deal with the impact of both on your investments. With regard to inflation, that can mean choosing investments that tend to offer a higher rate of return overall. Stocks, for instance, can outperform certificates of deposit (CD) rates or money market funds. However, investing in stocks does carry more risk.
You can also choose investments that move with inflation or are otherwise inflation-proof. Real estate is a great example. Property tends to appreciate in value over time and when inflation goes up, rental prices can increase in tandem. If you’re renting a property out, then you can ride with the tide so to speak when it comes to how much you charge.
Minimizing the Effects of Taxation
In terms of taxation, there are a few strategies you can use to minimize the effects. Some of the best ways to save on taxes as an investor include:
- Choosing longer-term investments, which are subject to the more favorable long-term capital gains tax rate.
- Contributing to tax-advantaged accounts, such as 401(k) or individual retirement accounts (IRAs).
- Allocating less tax-efficient assets, such as traditional mutual funds, to an IRA or 401(k).
- Harvesting tax losses to offset capital gains.
- Claiming all eligible deductions in order to shift into a lower tax bracket.
Understanding real return is important when deciding how to invest money. The more purchasing power you have, the further your dollars can go. If you’re just looking at nominal returns, you can end up with a skewed sense of how much your investment might be worth. For example, say that you’re eyeing an investment that has delivered a 15% rate of return to investors over the last 10 years.
That sounds good but it doesn’t tell you how inflationary changes or updates to the tax code may have affected the earnings investors actually got to keep over that same period. It’s possible that once inflation rates and taxes are factored in, the net return is negative or zero. That’s something you’d like to know before you invest. Talking to a financial advisor can help you come up with a plan for managing taxes on investments so that you can get the best real return possible for your money.
- If you need help calculating the real return on investment, consider talking to a financial advisor. A financial advisor can walk you through the numbers when deciding what to include in your portfolio. And finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool makes it easy to connect with three vetted financial advisors who serve your area. It takes just a few minutes to get your personalized advisor recommendations online. Get started now.
- Many investors confuse an investment’s returns with its yield. You never have to make that mistake again, though. Learn the difference between these two key concepts, along with how a combination of strong yields and steady returns can help you meet your financial goals.
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