If you’re like most people, you probably want to know what return you might expect before you invest. But to translate a given rate of return into actual income or growth potential, you’ll need to understand the difference between nominal return and real return, and how that difference can affect your ability to target financial goals.
Let’s say you have a certificate of deposit (CD) that’s about to expire. The yield on the new three-year CD you’re considering is 1.5%.
But that 1.5% is the CD’s nominal rate of return; it doesn’t account for inflation or taxes. If you’re taxed at the 28% federal income tax rate, roughly 0.42% of that 1.5% will be gobbled up by federal taxes on the interest. Okay, you say, that still leaves an interest rate of 1.08%; at least you’re earning something.
However, you also need to consider the purchasing power of the interest that the CD pays. Even though inflation is relatively low today, it can still affect your purchasing power, especially over time. Let’s say that consumer prices have gone up by 1% over the past year and you adjust your 1.08% after-tax return for inflation. Suddenly, you’re barely breaking even on your investment.
What’s left after the impact of inflation and taxes is your real return, because that’s what you’re really earning in actual purchasing power. If the nominal return on an investment is low enough, the real return can actually be negative, depending on your tax bracket and the inflation rate over time. Though this hypothetical example doesn’t represent the performance of any actual investment, it illustrates the importance of understanding what you’re really earning.
Knowing the difference between nominal and real return may help you make better decisions when it comes to investing your money. You’ll want to choose investments that match your financial goals and tolerance for risk. In some cases, the security an investment offers may be important enough that you’re willing to accept a low real return; in other cases, you may choose an investment that has the potential for a higher real return but carries a higher degree of risk.