Net Worth: How to determine your true net worth.

Remember back in school when you would get regular feedback on how great you were doing? That was fun, wasn’t it? Every 9 weeks or so you would get a sheet with your grades that told everyone exactly how hard you were working. If you lived in a cool place like me your grades even came in a little passport looking book. And your parents had to sign it! No hiding that test you didn’t study for!

As you got older, your worth was probably evaluated by a couple standardized tests (now everyone knew how smart you were, or not), and if you got exceptionally lucky, the state also started quizzing you and determining precisely how much you were learning. Then one day it stopped…

Suddenly, you were on your own and as long as you kept up with your taxes, nobody really checks up on how you’re doing. And I bet that’s just the way you like it. Here is the problem: you can’t improve what you can’t see. And when it comes to progress in life, it certainly didn’t stop in school. In fact school was really just the preparation for everything after.

So how can we measure progress in life? Well like it or not, we usually measure progress using money. Queue the angry mob!

Now before you grab your pitchfork and come for the Handy Millennial, just think for one second: what is it that you want? Do you want a house? Do you want a new car? How about a vacation? How about a child? Some time off to help your parents?

Sure, you could say achieving these is progress, but each of those was afforded with money, and you first had to prepare (hopefully) your finances. Most people think of their finances monthly. For example, people ask: Can I afford this payment? But the real question to ask is, what is the effect of this payment/purchase/life change on my net worth?

OK smart guy, what is your net worth then? Help me put together this financial puzzle.

Well put simply, your net worth is the value of all of the things you own minus how much you owe to someone else. Notice the funny way that sentence is worded: “The value of things you own…” minus “how much  you owe others.” Interesting… This is because we tend to own things (exchanging money for objects or services) while we borrow in cold hard cash. This creates something of a problem for the average person because the resale value of most things in life is darn close to zero. So while you may think your living room is filled with valuable possessions, the reality is that from a financial standpoint, it’s filled with a bunch of junk.

A simple way to figuring out your net worth is to take the following steps. First figure out what you own:

  • Log into your bank account(s) – find your balance
  • Log into your retirement account(s) – find your balance
  • Log into your investment account(s) – find your balance
  • Go on Zillow, find your estimated home value
  • Go on Edmunds, find your estimated car value
  • Think hard, did you forget any accounts from old employers?
  • Add $5. That’s how much everything else you own is worth (not to you, just to everyone else in the world).

Now add up everything. That’s the value of things you own. If you own a home and any investments – retirement or not – this number will fluctuate daily (and in practice by the minute) during the trading day. This is why people use financial tracking software.

Personally, I like Quicken, but there are many free alternatives: Mint.com, YNAB.com, PersonalCapital.com. Just remember, if it’s free, you my friends are the product.

Now let’s figure out what you owe:

  • Log into your mortgage provider – find the balance.
  • Log into your credit cards – find the balances
  • Log into your car loan – find the balance
  • Add any outstanding amounts you owe on TVs, couches, vacations, etc etc.

This is how much CASH you owe somebody else. Unlike the assets you own, this number doesn’t change. In fact, because of compound interest, this number actually grows(!!) as time progresses.

Now typically your Current Net Worth = Assets – Debts. Lets take a moment and breathe here. Hopefully what you see is a positive number. If not, we need to have a conversation, because everything you do in life must be supported by your net worth. Otherwise you simply don’t have enough tokens to level up. Sorry Mario.

This is where your conventional blog post/news article about net worth would end. But the trouble is that it just isn’t so simple. Because while your net worth fluctuates daily with the price of your assets, your net worth also fluctuates with the decisions you make.

Huh? Hows that? Well let me tell you. In this case, I will assume that most of my readers are in the United States. In the United States we have a progressive tax system. This means that each consecutive chunk of income is taxed at a higher rate. The logic here is that people who make less will pay less in taxes because well the first bit of your income (ideally) goes towards food and shelter. And we want everyone to be full and living in a dry place right? Here are the tax brackets of this system in 2017:

Marginal RateAnnual Income

10%

$0 to $9,325

15%

$9,325 to $37,950

25%

$37,950 to $91,900

28%

$91,900 to $191,650

33%

$191,650 to $416,700

35%

$416,700 to $418,400

39.60%

$418,400+

Now lets suppose that you have the following numbers that you found to calculate your net worth:

  • Savings – $15,000
  • Retirement (tax deferred) – $50,000
  • Home Mortgage – $50,000

Your salary is $30,000 per year and you are 40 years old. What is your net worth? If you said $15,000, you would be wrong. But how can that be? Well its because your calculation, and the calculation proposed in most advice posts, looks something like this 15,000 + 50000 – 50000 = $15,000. But you see my dear reader, it just ain’t that simple. Withdrawal from retirement accounts in the good ol’ US of A are subject to a 10% penalty if you are less than 59 and 1/2 years old. Withdrawals are also subject to tax because they are typically tax deferred and appear as income with regard to your taxes. So here is how much you could actually get out of your retirement account today in several steps:

  • After the withdrawal penalty: $45,000
  • Subject to 15% tax – 7,950*.85 = $6757.50
  • Subject to 25% tax – = (40,000-7,950)*.75 = $27,787.50
  • Net withdrawal = $34,545

Now using this number lets recalculate our real net worth today: 15,000 + 34,545 – 50,000 = -$455!!!!

So you see you do not have a positive net worth at all if you want to pay off the mortgage today. Let’s repeat this scenario in the case where we pay off the mortgage in yearly installments of $7,950, so in this case over 6.3 years.

  • After the withdrawal penalty: $45,000
  • Subject to 15% tax – 7,950*.85 = $6757.50
  • Net withdrawal = $6757.50*6.3 = $42,500

In this case our net worth is 15,000+ 42,500 – 50,000 = $7,500. So simply by taking a tax optimized approach to withdrawals you came out with a positive net worth. Even so, its still half of the net worth calculated by the simplistic approach.

Of course there are an infinite number of such possibilities. The key here is to keep in mind what you want to do with your money. If you want to use it today then your net worth is very different than if you want to use it over a long horizon of time. It’s important to know not only your current net worth but also the effect of your actions on your net worth.