*The following post was created as a collaborative effort between Luke DeBoer, CFP®, CBP of DeBoer Financial, and Taylor Ripka, CFP®, AWMA of Delta Capital Advisors.
Ready for a not-so-fun experiment?
Imagine something ridiculously financially awful occurs. I mean something that devastates your finances. I'm not talking about a series of bad decisions and bad luck or lack of planning that leads to a situation of financial hardship but rather a singular event that causes you to liquidate everything you own just to get by. This event could be anything really but for the sake of this exercise let's say you get sued. Not just sued but sued in an epic fashion; again, to the extent that you are required to liquidate everything. Since this is a completely made up scenario, let's take it a step further and say that you need to sell everything immediately, pay off all your debts, and then see what you have left over.
Ok, in all reality the probably of this, or any other event that would wholly wipe you out is very close to zero. Probably less likely than any number of things that we otherwise think are near impossible, like getting struck by lightning. However, it's an interesting thought in how it relates to the calculation of net worth.
The traditional way of calculating net worth is to take the value of all your assets and then subtract the aggregate amount of all your debt. The number that remains is your net worth. However, what exactly does this traditional equation tell us? We can't use this number for anything practical. In truth this number doesn't even indicate whether our financial success is impacting our or anyone else's lives. It's not a meaningless number, mind you. In fact, it's actually a fairly strong indicator of financial success and savvy. But though it may indicate financial savviness, the inverse isn't exactly true either. For example, I would argue that a 23 year old recently graduated person who has decided to save in a Roth IRA and is living beneath his/her means is financially savvy, though their net worth may not reflect it yet.
The point though, is that building wealth just for the sake of saying that your net worth is "$X" is a rather vain idea if not tied to a more tangible impact.
Perhaps we should all be much more interested in calculations of net worth in how they actually affect ours or other's lives. So for that reason I've been thinking through alternative views of net worth.
Here's one way: consider whether, and how much, that net worth provides income, or, put another way, does it move the needle towards financial freedom? Another way, and the primary point of this post, is to view net worth on a truly "net" basis. Perhaps we could call this the Net Net Worth or a Liquidation Net Worth.
So what are we talking about here with a Net Net Worth? There are 3 stages to this concept:
1.) The traditional calculation of net worth
2.) The net net worth calculation
3.) Why should we care or the "so what?"
Traditional Net Worth
The traditional idea of net worth ironically, given the name, uses gross numbers, not gross as "ew" but gross as in before subtractions.
John and Jane Doe have the following assets and liabilities (for the lay person: liabilities = debt):
Pre-tax 401(k): $150,000
Roth IRA: $40,000
Savings Account: $10,000
Auto Loans: $9,000
Credit Cards: $2,000
Student Loans: $14,000
So what we would do is add up all of John and Jane's assets, which equal $518,500, and then subtract out their liabilities, which equal $225,000, for a net worth of $293,500.
Depending on their age and their income they're probably feeling somewhere in-between okay and really good about this number. We care about age and income because ideally we're all converting some of our income every year to net worth, so we'd expect higher income and older individuals to have higher net worths than their younger, lower income counterparts, even if their spending, saving, and investing behaviors are similar.
All of this is well and good and this net worth number, as noted earlier, probably serves as a useful indicator of discipline, diligence, savviness, and possibly some good luck. However, the number itself doesn't tell us what the Doe's can actually do with their assets from a practical sense.
And so we would introduce alternative forms of net worth. A future post will tackle the income from net worth perspective but for now let's tackle the Liquidation Net Worth. The "What will I actually have if I'm forced to sell everything at once and pay off my debts all in a single day?" situation.
The Liquidation Net Worth (or the Net Net Worth)
Let's say John and Jane Doe are forced, for whatever reason, to sell everything they have and pay off their debts. They just want to liquidate everything to cash. What does this look like? What is actually left over? The number is very different than the number derived from the traditional net worth calculation.
Assets net of transaction costs and taxes:
We got here by adding:
Equation: $300,000 * .94 ; the .94 is to account for a 6% real estate agent fee.
Pre-tax 401(k): $100,500
Equation: $150,000 * .67 ; this one is going to be extremely variable based on how much other income the person/couple has already earned in that calendar year, what state they're in, how old they are, etc., however, we'll assume that John and Jane are under 59 1/2 and so incur a 10% penalty, have an effective tax rate of 16 percent Federal and an effective rate of 7 percent state. These numbers are just random selections, as this is just a representative example.
Roth IRA: $33,400
Equation: $40,000 - ($20,000 * .33) ; let's assume that John and Jane had contributed $20,000 into Roth over X number of years, any contributions can be withdrawn tax and penalty free at any time; the growth will be taxed and penalized the same way that an early withdrawal from a pre-tax 401(k) or IRA would be.
Savings Account: $10,000
The downside of a general savings account is that the deposits aren't tax deductible and the interest/growth is immediately taxed as well. The upside is that the funds are completely liquid with no penalty.
Equation: $3,500 * (1 - .43) ; While HSAs are the single most tax-efficient way to save, if used for either qualified medical expenses or saved until post-65, there is a significant downside if you withdraw the funds pre-65 for anything that isn't a qualified medical expense. The distribution is taxed as ordinary income and there is a 20 percent penalty.
We'll make the assumption that John and Jane are able to immediately sell their vehicles for their fair market value.
Taxes and transactions costs don't decrease your debt load, perhaps that's obvious; however, it does help to highlight why simply using the standard net worth equation can be incomplete as an analysis.
Liquidation Net Worth =
What you'll notice is that their net worth decreased by roughly 25% simply by accounting for taxes and transaction costs. This is not an insignificant number and hopefully will guide the reader towards taking actions to account for these wealth killers.
All of this may be interesting but education without application is pointless. So what shall we take away from this concept of the Liquidation Net Worth?
Keep an eye towards diversifying how and where you save your assets.
Try to balance short, intermediate, and long-term Liquidation Net Worth by balancing how and where you save your money between HSA, pre-tax 401(k)/Traditional IRA, Roth 401(k)/Roth IRA, taxable investment accounts, savings accounts, and possible other accumulation vehicles.
It's extremely important to take advantage of tax shelters if you want to maximize your long-term wealth accumulation. Accounts like pre-tax retirement vehicles (401(k), 403(b), etc.), Roth IRAs or Roth 401(k)s, and HSAs are all, generally speaking, fantastic avenues to build wealth. However, there use should probably be moderated by other wealth accumulation vehicles. Whereas an HSA may allow for the best long-term wealth accumulation, it also offers the worst short-term liquidity (outside of qualified medical expenses, of course), whereas a savings account offers relatively terrible long-term wealth accumulation potential it also offers the best short-term liquidity, as you'll notice that the value was the exact same in the class net worth equation as it was in the Liquidation Net Worth equation.
Make sure you're funding savings accounts and taxable investment accounts so that your short and intermediate-term liquidity needs don't force you to take money out of HSAs, 401(k)s, and Roth IRAs too early. On the flip-side, don't ignore HSAs, 401(k)s, and Roth IRAs either, as they allow for the greatest long-term wealth accumulation benefits. DeBoer Financial uses a concept called Retirement+, which is a framework that keeps tax diversification and efficiency top of mind, likewise, Delta Capital Advisors routinely talks to its clients about the Tax Triangle, which outlines the importance of filling up 3 distinct buckets of assets. This concept of account or tax diversification is a good one to keep in mind, the Liquidation Net Worth calculation simply gives us a point-in-time view of why that's important.
So what's your liquidation net worth? How are you saving your money? Take the anonymous survey below and then see how others are doing.