Pretax Rate of Return: Definition & Formula

KEY TAKEAWAYS

• 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. 

Summary

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.