How to Calculate the Effective After-Tax Yield

When people or businesses calculate their return on an investment, it is essential that they look at the after-tax rate of return, which takes into consideration the taxes that will have to be paid on the investment. The amount remaining after taxes are taken out is known as the effective after-tax yield. For example, if someone earns $1,000 in dividends on an investment, but they have to pay 20 percent in taxes, they really only earned $800 — their after-tax dividend yield.

Not only does calculating effective after-tax yield give a more accurate picture of the profitability of an investment, but it also allows investors to make more informed decisions when it comes to analyzing the tax implications of withdrawing certain investments.

Step 1: Find the Investor's Marginal Tax Rate

The marginal tax rate is the highest percentage of income tax that a person will have to pay. Because the United States has a progressive tax system, the marginal tax rate increases with higher income levels. This number differs from the effective tax rate, which is the amount that is actually paid in taxes. When calculating the after-tax rate of return, the marginal tax rate should be used.

Step 2: Calculate the Total Tax Rate

The total tax rate can be found by adding the percentages a person or business must pay in applicable taxes. If, for example, 22 percent is paid in federal taxes and 8 percent is paid in state taxes, the total tax rate would be 30 percent.

Step 3: Find the Effective Interest Rate After Tax

To find the percentage of yield kept after taxes, subtract the total tax rate from 1. Using our previous example, subtracting 0.30 from 1 leaves 0.70.

Step 4: Apply the After-Tax Return Formula

The effective after-tax yield can be found by multiplying the percentage of yield after taxes by the pre-tax rate of return. If the investment in this example returns 8 percent, that number would be multiplied by 0.70 to get an after-tax yield of 5.6 percent.

Comparing Investment Returns

A valuable aspect of the effective after-tax yield is that it allows for the comparison of profitability of taxable investments, like stocks, with tax-free investments, like municipal bonds. Likewise, it is important to examine the after-tax rate of return when comparing how investments perform in taxable brokerage accounts with their performance in tax-free retirement accounts like an Individual Retirement Account (IRA). Making investment decisions based on pre-tax returns is misleading and could cost people and businesses the opportunity to maximize their investments.