Compute Your Net Worth Once a Year

The following is a guest post from Marotta Asset Management. As I've said, I track my net worth monthly since I see it as the single-most important financial measurement. I find Marotta's measurement of "where you stand" net worth-wise interesting. If it's true, I'm on track to retire several years early. ;-)

Last year's markets took a heavy toll on your financial plan. You may have been on track at the beginning of the year, but now you must reevaluate. The storm has blown you miles off course, and not making any adjustments is destined to end in a shipwreck.

Everything in the financial markets has changed: energy, financials, real estate, bonds, equities, even the dollar. If you are within 20 years of retirement (age 45 to 65), it's critical to get your retirement planning updated. Computing your net worth annually is like taking a sextant reading to chart your course toward financial security.

Net worth gives you a snapshot of how much money would be left if you converted everything you owned into cash and paid off all your debts. Compute your net worth by creating four lists. 

• Liquid assets: An asset is something you own that has significant value. A liquid asset can be sold in a matter of days. Include personal bank accounts (checking, savings and money market), certificates of deposit, bonds, mutual funds, stocks and exchange-traded funds. Use values as of December 31 of the previous year so all of your amounts are calculated on the same day.

• Nonliquid assets: Nonliquid assets are those things you own that incur a penalty when they are sold. Include the value of your retirement accounts (IRAs, 401ks, 403bs, SEPs, profit-sharing plans and pension plans). Add real estate investments as well as the market value of your home. Use the assessed value. Other nonliquid assets may include proprietorships, partnerships or company stock in a firm that is not publicly traded. Add the cash value of any life (nonterm) insurance. Some people include jewelry, collectibles, cars and boats in this category. Although these items often have a high retail value, their true worth is often a small fraction of their initial cost. I do not recommend including personal property.

• Immediate liabilities: List what you owe to creditors. Immediate liabilities include credit card debt, car loans, student loans, other loans and any bill or debt that must be paid within two years.

• Long-term debt: For most people, long-term debt is primarily their home mortgage, but it may encompass other real estate or business loans.

The first time you gather all of this information will be challenging, but it gets much easier each subsequent year. By keeping an annual record of your net worth, you're creating a valuable financial planning tool.

Next compute three additional values. For your total assets, add your liquid and nonliquid categories; for your total liabilities, add your immediate liabilities and long-term debt; and finally, for your net worth, simply subtract your total liabilities from your total assets.

Use these net worth numbers to compute other values useful for reaching your financial goals. For example, your emergency reserve (liquid assets minus immediate liabilities) should be at least half your annual income. Any extra can be invested more aggressively for appreciation. Your debt load ratio (total liabilities divided by total assets) should be under 35%, with your home mortgage comprising most of your debt.

If you are trying hard to pay off your mortgage ahead of schedule instead of making a huge effort to save and invest, your attempts are laudable but mistaken. The quickest path to wealth includes holding a home mortgage you could pay off but you choose not to in order to take advantage of the tax benefits. The rich leverage wisely and invest.

A net worth statement helps you measure your progress toward retirement. At age 65 you can only withdraw 4.36% of your portfolio to maintain your lifestyle. In other words, to keep the same standard of living, you will need about 23 times what you spend annually.

Take your net worth and divide it by your annual take-home pay. The result shows you how many times your annual standard of living you have amassed in savings. If you are younger than 40, the number probably comes to less than five, which is adequate for now.

Progress toward retirement is not linear. This equation, determined by quadratic regression, estimates how much of your current net worth you should have saved given your age. It gives you a benchmark for determining if you are on track to retire by age 65:

• Savings should equal 0.0125 x^2 - 0.5746x + 7.4668, where x is your age in years.

• The result should be between zero and 23. That number tells you how many times your current annual income you should be worth. The formula is most accurate between ages 45 and 65.

• By age 45, you should be worth about seven times your annual spending. More sophisticated retirement planning includes the difference between taxable, tax-deferred and Roth accounts as well as Social Security guesses and defined benefit plans, but the method described here will approximate your progress.

If your net worth is higher, congratulations! You may be able to retire earlier than 65. For every 1 unit you are over, you could consider retiring about a year earlier. Conversely, for every 1 unit you are under your age's benchmark, you may have to work an additional year beyond 65.

Between ages 40 and 50, your net worth should increase by 1 unit of your annual spending every two years. That means your current net worth divided by your take-home pay should be 1 unit greater than it was two years ago. And if you are between age 50 and 65, your net worth should have increased this year by one times your take-home pay.

Want to retire younger? Try lowering your standard of living. Most retirees spend about 70% of the gross salary they earned while working. If you can live off 50% of your take-home pay, it's not as essential to save as much.

Need to catch up? Save more than 15% of your take-home-pay. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30, you should be worth 1.5 times your annual income. If your numbers don't match that ideal, an additional 0.3 times your annual income will help you get there. You could save an additional 10% of your income (for a total of 25%) for three years. If that's too much, try saving 20% (an additional 5%) for six years.

Money makes money. By the time you reach your 40s, you should have enough investments to be earning about half of your annual spending each year. Early in life what you save is most important for building wealth, but as you approach age 40 what you earn on your investments becomes critical. While you are young, the best advice a professional can offer is to "save." As you amass significant wealth, it is more pressing to "manage" well what you already have.

All financial planning begins with a clear understanding of your net worth. A PDF template on our website (www.emarotta.com/budget) can help you compute and keep track of your net worth each year. Contact us or visit our website to download a free copy.

Comments

[Josh]

"The rich leverage wisely and invest" I figured in 2008 we would have realized that the foolish leverage and end up broke, not the rich. For those that were rich and leverage are no longer rich.

[The Brandless Blog]

Hi,

Great tips there.

Computing net worth is actually part of the process of Financial planning and to even begin planning, we need to know where is our current position.

With technology, it is much simpler and easier to track our net-worth nowadays. If you look around the net, you can find quite a handful useful online money tracking websites that sprung out like mushrooms and I have to say they are quite comprehensive in terms of tracking the finance.

Computation of net worth is actually harder if we talk in terms of a family, especially with young couples. Do you agree?

Rendell
The Brandless Blog

[FMF]

Rendell --

Nope, don't agree. Usually computing net worth for younger couples is easier as there's less to compute.

[segfault]

"Savings should equal 0.0125 x^2 - 0.5746x + 7.4668, where x is your age in years."

Uh, is there a website with that calculator somewhere? And, shouldn't the calculation be dependent upon your income?

[jack]

Yeah, I agree with an earlier poster - it is frustrating to see another post where people misunderstand why a mortgage can be beneficial. It is not the tax breaks! When will people wake up and realize paying a dollar to save 25 cents isn't a good deal. Dave Ramsey is right about this. The reason to hang on to a mortgage is to prevent a cash flow issue and illiquidity. Yes, leverage is a factor, but it should be a minor one. Ultimately, if you can pay off the mortgage but choose not to, please don't let that be for the tax reasons! There may be reasons to take that path (some of them more unique than others) but it isn't taxes.

[CF]

I'm forgetting what ^ means in the equation. Segfault, the equation is dependent on your income, as it provides a multiple of your current income that you should have saved.

[Rob G.]

"Savings should equal 0.0125 x^2 - 0.5746x + 7.4668, where x is your age in years."

So if I'm 32 then 0.0125 (32)^2 - 0.5746(32) + 7.4668 = (0.0125 * 1024) - 18.3872 + 7.4668 = 1.8796

If I'm 45 then 0.0125 (45)^2 - 0.5746(45) + 7.4668 = (0.0125 * 2025) - 25.857 + 7.4668 = 6.9223

If I'm 65 then 0.0125 (65)^2 - 0.5746(65) + 7.4668 = (0.0125 * 4225) - 37.349 + 7.4668 = 22.9303

Seems to make sense. I wonder what rate of return this model assumes in its calculation?

[Jim]

Good article.

Here's the result for that formula based on ages 25-65:

25 = 0.9
26 = 1.0
27 = 1.1
28 = 1.2
29 = 1.3
30 = 1.5
31 = 1.7
32 = 1.9
33 = 2.1
34 = 2.4
35 = 2.7
36 = 3.0
37 = 3.3
38 = 3.7
39 = 4.1
40 = 4.5
41 = 4.9
42 = 5.4
43 = 5.9
44 = 6.4
45 = 6.9
46 = 7.5
47 = 8.1
48 = 8.7
49 = 9.3
50 = 10.0
51 = 10.7
52 = 11.4
53 = 12.1
54 = 12.9
55 = 13.7
56 = 14.5
57 = 15.3
58 = 16.2
59 = 17.1
60 = 18.0
61 = 18.9
62 = 19.9
63 = 20.9
64 = 21.9
65 = 22.9

[Eric N.]

Good article. Thanks!

[kitty]

"That number tells you how many times your current annual income you should be worth. "
"By age 45, you should be worth about seven times your annual spending."

I assume you meant to say annual spending in both cases, right?

"The reason to hang on to a mortgage is to prevent a cash flow issue and illiquidity."
If you don't have money. If you have money there is a different reason. You locked in a low rate and the interest rates went up, so you can earn more on your other investments, especially fixed income investments. I wouldn't use stock return here for comparison - mortgage rate is guaranteed whereas stocks' return isn't, but safer investments such as treasuries, investment grade bonds or even CDs. Holding to a mortage could also be a strategy if you believe we'll get high inflation in future. The latter is the reason my (relatively rich) friends used when they took a mortgage to buy a vacation home just recently even though their brokerage account alone has 3 times the price of the new home.

Tax deduction is an important factor in the comparison of the rate you pay on your mortgage and the income you can get from your investments - some of them may be taxable but others may be tax free.

[Margo]

There are a couple words missing in the article. The formula gives you the factor by which you multiply your income.

E.g., I am 26 and my factor is approx. 1.0, so I should have 1 times my salary.

By age 30, when the factor is 1.5, then I should have 1.5 times my salary.

[thomas]

I think I'll skip my 2008 net worth as it will just depress me.

[PK]

FYI for people, the first derivative of this equation show that before age 22.984 your net worth should be decreasing. I would wait until age 23 before applying this rule.