Question

The nominal interest rate is 4 percent, the inflation rate is 1 percent and the tax rate is 20 percent. Given U.S. tax laws, how is after-tax real return computed?

Answer 1

The after-tax real return is calculated by subtracting the inflation rate from the after-tax nominal interest rate, which is the nominal rate adjusted by the tax rate. In this example, the after-tax real return is 2.2 percent.

Step-by-step explanation:

To compute the after-tax real return given a nominal interest rate of 4 percent, an inflation rate of 1 percent, and a tax rate of 20 percent in the context of U.S. tax laws, we need to consider both the reduction in purchasing power due to inflation and the impact of taxes on the interest earned. First, we calculate the real interest rate by subtracting the inflation rate from the nominal interest rate, which in this case is 4 percent - 1 percent = 3 percent. Next, we need to adjust the real interest rate for taxes by multiplying the nominal interest rate by (1 - tax rate), which would be 4 percent * (1 - 0.20) = 3.2 percent. Then, to find the after-tax real return, we subtract the inflation rate from the after-tax nominal return: 3.2 percent - 1 percent = 2.2 percent.

Answer 2

After-tax real return is calculated by first finding the after-tax nominal return and then adjusting it for inflation. For a nominal interest rate of 4%, a tax rate of 20%, and an inflation rate of 1%, the after-tax real return is 2.2%.

Step-by-step explanation:

To compute the after-tax real return, we first need to calculate the nominal return after taxes and then adjust it for inflation. With a nominal interest rate of 4%, a tax rate of 20%, and an inflation rate of 1%, the calculation would be as follows:

• Calculate the after-tax nominal return: 4% nominal interest x (1 - 0.20 tax rate) = 3.2% after-tax nominal return.
• Calculate the real return: 3.2% after-tax nominal return - 1% inflation rate = 2.2% after-tax real return.

Therefore, an investor will effectively earn a 2.2% return on their investment after considering both taxes and inflation. It is important to note that U.S. tax laws tax the nominal gain, not accounting for inflation, which can lead to taxing on money that effectively has not gained any real value.