PRETAX RATE OF RETURN

The rate of return on an investment that does not take the taxes the investor must pay on this return. Because individuals' tax situations differ and different investments attract varying levels of taxation, the pretax rate of return is the measure most commonly cited for investments in the financial world.

Since dividends on stocks may be taxed at a different level from interest income or capital gains, for example, the pretax rate of return enables comparisons to be made across different asset classes. However, it is the after-tax rate return that is most important to investors.

For example, assuming a capital gains tax rate of 15%, a stock that provides a 5% pretax rate of return would have an after-tax rate of return of 4.25%. However, suppose that a municipal bond that is tax-exempt and has a pretax return of 4.25% and would therefore also have the same after-tax rate of return. In this case, an investor may choose the municipal bond because of its greater degree of safety and the fact that its after-tax return is the same as that of the more volatile stock, despite the latter having a higher pretax rate of return.