How do I calculate after-tax return on a taxable investment portfolio?

Question

AcadiFi · Accepted Answer

After-tax return accounts for the drag taxes impose on pre-tax returns, differentiating by income type because different tax rates apply to ordinary income, qualified dividends, and capital gains.

Basic formula: rAT = rPT * (1 - t), where rAT is after-tax return, rPT is pre-tax return, and t is the effective tax rate on that return component.

Multi-component formula: rAT = rI*(1-tI) + rD*(1-tD) + rCG*(1-tCG), where rI is interest/ordinary income, rD is dividend income (qualified), and rCG is capital gains return. Apply respective tax rates.

Worked example: the Okonkwo family holds a $500K portfolio returning 2% interest (taxed at 35% ordinary), 1.5% qualified dividends (taxed at 20% + 3.8% NIIT = 23.8%), and 4% realized capital gains (long-term, taxed at 20% + 3.8% = 23.8%). Pre-tax return = 7.5%. After-tax = 2*(1-0.35) + 1.5*(1-0.238) + 4*(1-0.238) = 1.30 + 1.143 + 3.048 = 5.49%. Tax drag = 2.01%.

Accrual versus deferred methods: accrual-equivalent return assumes taxes are paid continuously as returns accrue, producing the simple formula above. Deferred method accounts for unrealized capital gains that are taxed only upon sale, allowing compound growth on the deferred tax. For long holding periods, deferred tax treatment significantly reduces effective tax rate.

Deferred capital gain formula: after n years, wealth factor = (1 + rCG*n) * (1 - tCG) + tCG * basis factor. The effective annual after-tax rate trends lower as holding period extends — a 20-year hold with 7% pre-tax growth produces about 5.8% after-tax rate, better than the accrual equivalent.

```mermaid
flowchart LR
  A[Pre-Tax Return] --> B[Split by Type]
  B --> C[Ordinary]
  B --> D[Qualified Div]
  B --> E[Cap Gains]
  C --> F[After-Tax Total]
  D --> F
  E --> F
```

For CFA exam: recognize whether a scenario calls for accrual (income-heavy) or deferred (growth-heavy) treatment, and always compute the tax drag to compare strategies.

How do I calculate after-tax return on a taxable investment portfolio?

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