I routinely read articles and posts screaming about knowing your Net Worth. Each time I read one the first thing that catches my eye is how they calculate Net Worth. There are a multitude of ways to calculate your Net Worth, each with pluses and minuses. For the purposes of this calculation let’s consider a hypothetical person named Joe. Joe has the following assets and liabilities:
|Retirement Accounts Pre Tax||$200K|
|Retirement Accounts Post Tax||$200K|
Assets to Liabilities
The easiest of these is the simple assets-liabilities with everything included. In this case Joe is worth $1.020 Million dollars. The problem with this calculation is depending on its utilization, certain assets and liabilities might make sense to be excluded. For example, if you’re checking to predict what your net worth will be 2 years from now, should you consider an asset that depreciates like a car? Probably not as that asset will likely be worth a lot less.
Minus Depreciating Assets
This leads us to the second possibility, the same calculation with the removal of assets that depreciate (or decrease in value over time). In this case, Joe is worth $1M dollars. The thing is, what if your purpose was to understand how much net worth you have to invest or cover your expenses? Well then any asset that you likely could not sell without incurring a replacement reoccurring expense should not be included. So for example your home equity might not count since you still need to pay for a place to live even if you sell your home. This leaves Joe with $800K.
Minus Home Equity (Accredited Investor)
This third possibility is what the federal government uses to determine if you are an “Accredited Investor”, or someone who can be trusted to invest in more exotic investment vehicles due to the amount they have to invest. The assumption is that if they have a lot to invest perhaps they actually know how to invest so they will not be taken advantage of.
However, these are not the limits of methodologies. I have seen others do combinations of the following for various reasons:
- Consider recalculating pre tax accounts like a 401K as post tax account by removing the amount equal to your tax bracket. This will show you what the assets will be if you don’t succeed in managing your tax bite for your retirement later in life. In this case, if Joe is in the 25% tax bracket he has: $200K*.75+$200K+$400K= $750K
- Do not consider your retirement account/401k because the money is not accessible until retirement without jumping through hoops. One could also consider that the government could change tax laws and thus take a considerable portion of these accounts. In this case, if we build on the first 3, Joe has $400K.
- Do not consider your home equity but consider your home liability. This shows your expense impact of the liability while remembering the home equity is not available for you to spend. In this case, building on everything previously, Joe has $300K.
Our Net Worth Measurement, Goal Based
With so many different options it is very important to understand which methodology is being used and what the goal is in the context of its usage. As you can see from the above examples it can be the difference between having over $1M and $300K.
When calculating my retirement positions I actually look at my assets through a slightly different lens than the above. I’m more concerned with what income my assets will produce. As such, I tend to look at my assets in terms of their income potential per year. In this case, I remove the Home Equity and Car assets, and multiply the remainder by 4%. In comparison to my expenses this gives me a good look at where I am. Why use 4%? Well besides the Trinity study that shows that a 4% withdrawal rate is sustainable over 30 years, I can also look at a composite view of the stock market, and bond fund return over the last 30 years and see this is a likely scenario. Remember that past performance does not guarantee future performance.
If I had something more tangible like rental property I could also calculate my return by looking at my rent. Combine these items and I get a similar picture to the above, but in context of my debts. In the case of Joe this would mean he has enough to cover $32K in expenses each year.
So the important take away here is to calculate Net Worth in the context of the question you are trying to answer, and be clear and consistent about the measurement you use. However, it can be fairly demotivating to watch your total Net Worth take a dive due to stock market gyrations in spite of large deposits, as such always remember to check if Net Worth is a Relevant goal.
Which measurement is best for you?