Tax Equivalent Return
Vs. After Tax Return
While
evaluating taxable returns vs. tax-free returns, an investor needs to compare
the numbers on common platform. The Tax-Equivalent Return formula can help an
investor decide if a tax-free investment will give him a better return than a
taxable investment.
Tax Equivalent Return: is the return an investor would
have got after adding the tax benefit on a tax free return.
So
Tax
Equivalent Return = Tax Free Return(%) + Tax Benefit (%)
This Tax Benefit would depend on the Tax Slab an Investor falls into. That means
two investors can look at the same Tax Free Investment but have different Tax
Equivalent Returns if they fall into different Tax Brackets.
The higher the Tax Bracket of an Investor higher would be the Tax Equivalent
Return.
After Tax Return: This the actual return an investor
makes after deducting the tax on a taxable investment. Or it is the return net
of taxes.
So
After
Tax Return= Stated Return (%) - Tax Outgo (%)
Formula and Examples of Tax Equivalent Return and After Tax Return
The Tax
Equivalent Return
formula states the tax-free return
in terms of what an investor need to earn on a taxable investment to have the
same return post taxes. The tax-equivalent return will be higher for investors
in the higher tax brackets.
The tax equivalent return formula is used to compare the return between a
tax-free investment and an investment that is taxed.
Tax-Equivalent Return = Tax-Free Interest Rate ÷
(1 – tax rate)
The
After Tax Return is the actual
return after adjusting the taxes to be paid on a taxable investment.
After Tax Return = Taxable Interest Rate × (1 –
tax rate)
We will now highlight the difference between TER (Tax Equivalent Return) and
(ATR) After Tax Return by an Example
Suppose an investor has the choice between two fixed-income options:
A
6.50% taxable return or a 5.25% tax-free return. The Tax rate for the investor
is assumed to be 30%.
So, now the question is which one of the two options should the investor choose?
We would use the formula of Tax-Equivalent Returns in order to arrive at a
common comparison mode. The formula is:
Tax-Equivalent Return =
Putting the above figures in the formula:
=
=
= 7.50% =TER
This means that if the investor falls in the 30% tax bracket, then he needs to
find a fixed income investment that yields AT LEAST 7.50% BEFORE TAX in order to
get the same after-tax return of a 5.25% tax-free. In this case the investor
would be in a much better position purchasing the tax-free option.
The same thing can be looked from another angle. We again assume that the
investor falls in the tax bracket of 30% tax bracket and you find an investment
with a taxable return of 7.50%. Since this return is taxable, the investor would
not get to keep it all. So, a smart investor needs to calculate how much of that
return is going to be left after taxes.
So, we can perform the following calculation, which is an alteration of the
formula used above:
After Tax Return = Taxable Interest Rate × (1 – tax rate)
= 7.50 × (1 – .30)
= 7.50 × .70
= 5.25%
This is how both the concepts work
We can also calculate what the After-Tax Return is on the 6.50% return:
= 6.50 × (1 – .30)
= 6.50 × .70
= 4.55%
So which one out of 5.25% tax-free or 4.55% tax-free would be chosen by an
investor is an easy question to be answered.
What needs to be noted is that the higher the tax bracket of an investor, the
more advantageous a Tax-free return becomes for him. We can have a look at the
graphic to illustrate the same concept:
|
Tax Bracket
|
Tax Free Return
|
Tax Equivalent Return
|
|
10%
|
5.25%
|
5.83%
|
|
15%
|
5.25%
|
6.18%
|
|
20%
|
5.25%
|
6.56%
|
|
25%
|
5.25%
|
7.00%
|
|
30%
|
5.25%
|
7.50%
|
|
35%
|
5.25%
|
8.08%
|
Can
we compare a Tax Equivalent Return and After Tax Return to judge which is better
investment?
The answer is no.
We can compare a Tax Equivalent
Return to a Stated Before Tax Return.
We can compare a Tax Free Return
with an After Tax Return
Therefore it is very important for investors to
understand the meaning of Tax Equivalent Return and After Tax Return and the
comparison between two returns can be made only before the tax considerations or
after tax considerations. Also because difference in Tax Slabs what may look good for a high-income
investor in higher tax bracket may not necessarily be good for lower income
investor in lower tax bracket.
....
