How to Compute Your Net Worth, How High Your Net Worth Should Be, and Be Sure to Do It Once A Year

Regular Free Money Finance readers know that I think your net worth is the one financial measurement that counts most when determining your financial health. In fact, "growing your net worth" is what this site is all about.

Therefore, I'm please to present this article on how to compute your net worth. The piece is in line with my thoughts and feelings on net worth as it clearly states in bold text: "All of financial planning begins with a clear understanding of your net worth." The article's been provided to Free Money Finance courtesy of Marotta Asset Management. Here goes:

The yearly cycle of financial planning begins with computing your net worth at the start of each New Year. Net worth is a snapshot of how much money would be left if everything you owned were converted into cash and all debts were paid off. Your net worth is computed by creating four smaller lists.

Liquid assets: An asset is something that you own that is worth significant value. A liquid asset is something that can be sold in a matter of days. Include all of the following types of investments: personal bank accounts (checking, savings, money market), certificates of deposit, bonds, mutual funds, stocks, and exchange traded funds. Use values as of the end of last year so that all of your amounts will be on the same day.

Non-liquid assets: Non-liquid assets are those things that you own that cannot be quickly and easily sold without penalty. In this category include the value of your retirement accounts (IRAs, 401ks, 403bs, Keoghs, Profit Sharing Plans, and Pension Plans). Also include any real estate investments including the market value of your home. In the Charlottesville area using the assessed value is an easy indicator of the market value of your home.

Other non-liquid assets can include business interests such as proprietorships, partnerships, or company stock in a company that is not publicly traded. You can also include the cash value of any life insurance that is not term insurance. These may not be the best investments precisely because they are not liquid assets, but they should be listed as part of your net worth. Some people include personal property such as jewelry, collectibles, cars, and boats in this category. While these often have a high retail value, their true worth is often a small fraction of their initial cost. I recommend not including personal property.

Immediate Liabilities: Now list what you owe to creditors. These are called liabilities and are also divided into immediate liabilities and long-term debt. Immediate liabilities include credit card debt, car loans, student loans, and any other loan, bill or debt that must be paid within two years.

Long Term Debt: The last category lists long-term debts. For most people this is primarily their home mortgage, but may include other real estate or business loans.

It may be difficult the first time you gather all of this information, but in subsequent years it becomes much easier. By keeping a record of your net worth each year, you have a valuable tool for financial planning.

Now compute three additional values: Your Total Assets are simply your Liquid Assets plus your Non-Liquid Assets. And your Total Liabilities are your Immediate Liabilities plus your Long Term Debt. Finally, your Net Worth is simply your Total Assets minus your Total Liabilities.

Now that you have computed your net worth, you can use these numbers to compute other values useful for reaching your financial goals.

Emergency Reserve: First, see how much of an emergency reserve you have. Take your Liquid Assets and subtract your Immediate Liabilities. This number should be at least half of your annual income as an emergency reserve. If this number is negative, your financial choices are severely limited no matter how much you have in your retirement accounts. Any amount over half your annual income can be invested more aggressively because you can afford to suffer a short-term loss without jeopardizing your emergency fund.

Debt Load Ratio: Next determine how much your assets are leveraged by debt. Take the Total Liabilities and divide by the Total Assets to determine your Debt Load Ratio. This number should not be over 35% with your home mortgage comprising the majority of your debt. If the number is below 15% you are probably missing out on the leverage and tax benefits of a home mortgage. These benefits can be substantial. Most millionaires have a home mortgage debt that they could easily pay off, but chose not to because they enjoy the tax benefits and ability to invest more in the markets.

Progress Toward Retirement: In order to retire at age 72 and have sufficient funds to maintain your standard of living you need about sixteen and a half times your annual income. If you save 15% of your take home pay between age 20 and age 72 you should have sufficient savings in retirement. This is despite the fact that you will have saved less than 7 years worth of pay and many of those years will have been at a lower rate of pay.

To determine your progress toward retirement, take your net worth and divide by your annual income. This is how many times your annual income you have amassed in savings. If you are under 30, the number is probably less than one and a half. That’s ok; it is supposed to be.

The progress toward retirement is not a linear function. To those of you wondering if the math you studied in high school is useful, the following equation was determined by quadratic regression. It estimates how much of your current net worth you should have saved given your age. This gives you a benchmark for determining if you are on track to retire by age 72.

Compute your adult years by taking your age and subtracting 20. This formula works between 20 and 72, so if you are younger than 20 count your adult years as zero.

Take your adult years and divide by 240. Then add one tenth (0.1). Finally, multiply the result by your adult years. The resulting number should be between zero and sixteen and a half. That number is how many times your current annual income you should be worth.

You will need your calculator. For example if you are 30 years old then your adult years are 10 (30 minus 20). Ten divided by 240 equals 0.04167. Add one tenth to get 0.14167. Then multiply by your adult years again. The result is 1.4167. By age thirty you should be worth about 1.4 times your annual salary.

Age Net Worth divided by Annual Income

• 20 -- 0.00
• 30 -- 1.42
• 40 -- 3.67
• 50 -- 6.75
• 60 -- 10.67
• 70 -- 15.42
• 72 -- 16.47

If your net worth is a higher multiple than this formula: Congratulations! You are on the path to retiring earlier than 72! For every 0.5 you are over, you could consider retiring about year earlier. Conversely, for every 0.5 years you are under your age’s benchmark you may have to work an additional year beyond 72.

Want to retire younger? Try lowering your standard of living. In retirement, most people spend about 70% of their take home pay while they were working. If you can live off 50% of your take home pay, you don’t need as much savings to maintain that lower lifestyle.

Need to catch up? Save more than the 15% of your take home pay normally recommended. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30 you should be worth 1.4 times your annual income. What should you do if you are only worth 1.1 times your annual income? Normally, to stay on track you need to save 15% of your income each year. In order to catch up you need an additional 0.3 times your annual income. One option would be to save an additional 10% of your income for three years. If saving 25% of your income is too much, try saving 20% (an additional 5%) for six years.

All of financial planning begins with a clear understanding of your net worth. We have a template in PDF format on our website that you can use to help you compute and keep track of your net worth each year. Please contact us or visit our website to receive a free copy.

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Good stuff!!!!

My net worth is 50% higher than the multiple he gives for my age, so I guess I'm doing ok. ;-)

Stay tuned -- in the future I'll be running a few additional pieces from this site. I think you'll appreciate what they have to say.

Comments

[Dale]

Yes! Every article on retirement savings should have some advice on catching up. Even if you are behind in your retirement savings, or don't have any at all, you can make up for at least some of the lost time. Starting early is better than starting late, but starting late is still better than giving up.

[Mike]

While I compute my net worth, I quibble with some of the points in the article.

I base my retirement estimations on what I'm _spending_, not earning. My promotion and salary increase that I got last year didn't suddenly make my retirement prospects suddenly dimmer as the formula would imply. Since I didn't increase my spending with the promotion but rather increased my savings, my retirement prospects are brighter.

When calculating your net worth, $1 in a 401K or other tax deferred account should not be regarded the same as a dollar on which you've already paid taxes, whether that dollar is in a Roth IRA or other post tax account.

When I calculate my net worth, tax-deferred accounts are first reduced by my current marginal tax rate. Contrary to commonly held beliefs that your marginal tax rate will be lower in retirement, it can easily be higher since $1 of income can also result in taxing of $.50 or $.85 of Social Security benefits. So $1 tax-deferred now at a 25% marginal rate, and later withdrawn from a 401K at a marginal tax rate of 15% would be effectively 22.5% or 27.75%. Although the exclusion on taxing of Social Security benefits is $25K for a single person, after 15 years at a modest inflation rate of 3%/year would be equivalent to only $16K in today's dollars since the exclusion is not indexed for inflation. That's also assuming that Bush's tax cuts are really, really permanent. Since I already have substantially more in tax-deferred accounts than the average person, I'm looking at the realistic possibility of paying more in taxes when I withdraw the money than I'm currently deferring. I'm hoping that my employer will offer the Roth 401K as an alternative to the traditional 401K.

I calculate the worth of my titled property. I put the value of my house at 75% of the tax appraisal to account for the cost of preparing it for sale and paying real estate commisions, etc. Car value is the Edmunds wholesale value. Furniture and other possessions I don't bother with. How much could I really get for all my personal items if I held a garage sale?

[tiredbuthappy]

This is one of the best articles I've seen in a long time. The formula does seem more fine-tuned than others for benchmarking your net worth. I also really like commenter Mike's idea, which was also addressed in the article, about calculating retirement needs based on SPENDING instead of on INCOME. By that measure, people whose savings rate is negative actually need MORE than their current annual income to maintain their lifestyle once they retire. Clearly, this is impossible. Yet another reason to keep spending down.

This benchmark doesn't really tell me anything new about my situation. At 29, I'm ahead. At 43, my spouse is behind. If we average out between our two ages, and look at our combined assets and liabilities, then we are a little behind but it's not irremediable (sp?). The numbers required for catching up are scary and out of reach, but these numbers are always scary. All I can do is increase my savings rate every single year, and try to get better and better at holding my spending down. I'm gonna need that skill in retirement.

It's interesting that he tosses off that 15% savings rate so glibly. Time was, 10% was considered enough. It reminds me of a Wall Street Journal article I read on the plane a couple months ago called something like "Why 15% is the new 10%".

[Tom Bowford]

im 65 and want to retire. I have 10k in the bank but ow 20k on my credit cards. Is there something the formula can help me figure out.

[FMF]

Tom --

Probably not. I suggest getting some financial advice from a successful friend, family member, etc.