The nominal rate of return is the amount of money your original investment generated before deducting expenses like investment fees, trading costs, and taxes.

While it does not represent your actual return, it offers a basic way of gauging an investment's performance over an investment period. It can also be useful for comparing different investments.

This educational article offers helpful tips and explanations that investors might find insightful as it relates to the nominal rate of return. We discuss how they're calculated and how to arrive at the real value generated by your original investment amount.

Key Takeaways

• A main limitation to using the nominal rate of return is it doesn't account for factors that can erode an investment's gains.
• Despite its limitations, calculating the nominal rate of return can make sense when comparing the performance of multiple investment vehicles.
• Your after-tax rate of return is a percentage figure that accounts for taxes. The nature of your investment, how long you've held it, and your tax bracket influence it.
• An investment's real rate of return provides an accurate picture of how much an investment has gained over time. It accounts for inflation. 

Calculating an Investment's Nominal Rate of Return

You calculate an investment's nominal rate of return by subtracting its original investment value from its current market value (also called the current investment value). Then, you divide the figure you get by the original investment value. Doing so helps you calculate whether your original investment amount has appreciated or depreciated.

Here's the formula for how it's calculated:

Nominal Rate of Return = (Original Investment Value - Current Investment Value) ÷ Original Investment Value 

Nominal Rate of Return Calculation: Example

Let's pretend that you invested $200,000 in a mutual fund or similar investment options for one year and became a stockholder in fast-growing companies. At the end of the investment period, your investment had increased to $210,000.

The $200,000 you invested is your original investment value, whereas the $210,000 is your investment's current market value.

Using the above formula, you can arrive at your investment's nominal rate of return as follows:

$210,000 - $200,000 = $10,000 
$10,000/ $200,000 = 0.05 or 5%

Your investment in this scenario generated a 5% nominal return.

Limitations Associated With Relying on the Nominal Rate of Return

Generally, it isn't advisable to rely solely on the nominal rate of return because the metric doesn't factor:

• Inflation rate or purchasing power
• Different tax rates applied to the various investments (e.g., rates of corporate bonds vs. municipal bonds)
• Other expenses associated with investing

Let's use the above-mentioned scenario as an example: You've earned a 5% nominal rate of return on your $200,000 investment.

Imagine that inflation rates rose to 2.5% during the same period. The rising prices will erode your return by 2.5% inflation, leaving your actual return at 2.5% (5% - 2.5% inflation). This percentage doesn't account for the other costs your investment will incur (like taxes).

For the above reason, you'll need to calculate your real rate of return to ensure that outside forces don't erode your gains.

You should also be aware that historical performance does not guarantee future results, and all investments carry risk, including the potential loss of principal. Financial markets fluctuate, and investors should fully understand the risks before making any decisions.  

Nominal Vs. After-Tax Rate of Return 

Unlike the nominal rate of return, the after-tax return rate accounts for taxes on your investments.

There are a handful of factors that determine how much your investments will get taxed. They include:

The Nature of the Investment

Investments have different tax rates and after-tax rates of return. Some don't attract taxes at all.

For example, your portfolio could have a municipal and corporate bond that produces the same nominal rate of return. However, since municipal bonds are mostly tax-exempt, you'll only have to pay taxes on the corporate bond. Thus, the after-tax rate of return on the corporate bond will be significantly lower than the return on the municipal bond.

How Long You've Held Your Investments

The IRS considers investments held for more than one year before they're disposed of as susceptible to long-term capital gains or losses, while investments held for a year or less attract short-term capital gains or losses.

Your Tax Bracket

Your tax bracket influences how much you'll owe in capital gains taxes. It's important to consult a tax advisor to ensure you're aware of how taxes apply to your specific investments. Tax brackets are based on your income level, and the IRS provides specific guidelines that must be followed. Based on your annual income, you can fall into one of three tax brackets. They are 0%, 15%, and 20%.  

From the IRS website:

"A capital gains rate of 0% applies if your taxable income is less than or equal to:

• $44,625 for single and married filing separately;
• $89,250 for married filing jointly and qualifying surviving spouse; and
• $59,750 for head of household.

A capital gains rate of 15% applies if your taxable income is:

• more than $44,625 but less than or equal to $492,300 for single;
• more than $44,625 but less than or equal to $276,900 for married filing separately;
• more than $89,250 but less than or equal to $553,850 for married filing jointly and qualifying surviving spouse; and
• more than $59,750 but less than or equal to $523,050 for head of household.

However, a capital gains rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the 15% capital gain rate."

Here's the formula for calculating your after-tax rate of return:

After-Tax Rate of Return = (Current Market Value - Original Investment Value - Tax Sum) ÷ Original Investment Value

Working out your after-tax rate of return will take you a step closer to determining the true return on your investment.

Why Calculate the Nominal Rate of Return At All?

Despite its limitations, the nominal rate of return is an important metric that any investor can use to compare their portfolio investments quickly.

However, it is important to note that the nominal rate of return alone does not provide a complete picture of an investment's performance. Investors must also consider inflation, fees, and taxes when assessing returns to ensure a realistic view of their financial situation. 

The Real Rate of Return

An investment's real rate of return is the true return it realizes within a given period. It's represented as a percentage and accounts for inflation.

How to Calculate the Real Rate of Return

To calculate an investment's real rate of return, subtract the current inflation rate from your nominal rate of return. Please note that you'll be using percentage figures in your calculations. Thus, you'll need to work out your nominal rate of return first.

The formula is as follows:

Real Rate of Return = Nominal rate of Return - Inflation Rate

For example, if your investment has grown by 10% (the nominal rate), and the inflation rate is 4%, then your real rate of return is 6%.

Get the Most From Your Investment Returns

Investments in startups and crowdfunding opportunities are highly speculative and come with significant risks. Historical performance is not indicative of future returns, and investors must be prepared for the possibility of losing their entire investment. Crowdfunding investments are generally illiquid, meaning you may not be able to sell or trade your shares for a long period, if at all. Additionally, there are strict annual limits on the amount non-accredited investors can invest, depending on income and net worth, per SEC Regulation Crowdfunding (Reg CF).

StartEngine provides access to early-stage startups and speculative investment opportunities. Investors must understand that these investments carry heightened risk, are not guaranteed to provide returns, and could result in significant losses. Investments are illiquid, and you may not be able to exit your investment for an extended period. Consult with a financial advisor before investing, and review all risk disclosures carefully.

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