You bought XYZ stock in January 2010 for $5,000. You decide to sell it today for $5,600. How much is your investment really bringing you?
-Your total return is 12% ($5,600/$5,000 = 1.12).
-Inflation makes your money worth less as prices rise. If inflation is 2%, then 12%-2% = 10% inflation adjusted return.
-Now you need to subtract taxes. If you are in the 28% tax bracket, Uncle Sam gets 28% and you get 72%. So 10% x 0.72 = 7.2%. Therefore, your after-tax, inflation adjusted return is 7.2% or $360 ($5,360/$5,000 = 1.072). For investors in higher tax brackets, the effects will be larger. The tax picture is better for stocks held long-term (>1 year) and is the reason I recommend not selling stocks held less than one year.
Stocks held long-term (>1 year): 5% for tax payers in the 10% and 15% tax bracket. 15% for all other tax brackets.
Stocks held short-term (<=1 year): Taxed at standard tax rate up to 35%.
As you can see, inflation and taxes really cut investment gains. If you are interested in a lot more detail, helpful information can be found in IRS Publication 550 (Investment Income and Expenses) http://www.irs.gov/pub/irs-pdf/p550.pdf and IRS Publication 564 (Mutual Fund Distributions) http://www.irs.gov/pub/irs-pdf/p564.pdf.