CHICAGO — As the old saying goes, “knowledge is power.” Arguably nowhere is this truer than in how you handle your money. Knowing your true net worth is an essential part of building and maintaining a sensible approach to your financial affairs.
A precise knowledge of where you stand will help you make appropriate investment decisions, demonstrate how to handle debt, plan your estate, and other important financial matters. Equally important is the psychological comfort that comes with knowing where you really stand on the financial landscape.
At first glance, calculating your net worth may look like a quick and easy task; just add up all of your assets, subtract your liabilities, and you have it. But calculating true net worth is a bit more complicated than that. Among the easiest things to overlook when calculating liabilities are the costs associated with such things as real estate brokerage commissions and taxes resulting from liquidating certain assets such as 401(k) plans.
As part of determining your true net worth, you should take into account what it would take to turn these assets into cash:
Liquidating or taking withdrawals from taxable investment accounts or conventional retirement accounts triggers both federal and state income taxes that can be considerable.
For example, say you have $500,000 in a taxable brokerage account that includes $100,000 in investment profits. If you held these securities for at least one year, selling them would incur a federal income tax of $15,000. Thus the true value of that account is $485,000, not $500,000. You might also trigger state taxes, which would reduce the value further.
Also, liquidation or withdrawals from conventional IRA or 401(k) accounts will also trigger income taxes applicable up to the full amount of the account. Thus the true net worth value of those accounts is less than the face value, depending on your marginal income tax rate. Also, a withdrawal before age 59½ will trigger a federal penalty of 10% in most cases. (Withdrawals from Roth IRAs or Roth 401(k) accounts do not trigger taxes.)
A major part of net worth for many people is the market value of their home, but that must take into account brokerage commissions and possible taxes. Real estate brokers typically charge up to 6% to sell a home.
A single person will usually qualify for a tax-free capital gain of up to $250,000 on the sale of a primary residence, provided the owner has lived there for at least two of the last five years. The capital gain is up to $500,000 for a married couple. Thus, you must take into consideration any possible capital gains taxes attached to real estate values when calculating true net worth. Sale of any non-residence properties you own will be subject to the same capital gains taxes.
We all like to throw in an estimated value for our personal property, such as automobiles, boats, jewelry, even collections of art or hobbies, when calculating net worth. Arguably, this is the area where overestimating of value is most likely to occur.
Take automobiles, for example. Nowhere is the depreciation rate higher than it is on the purchase of new cars. On average, they say, the market value of a new car purchase drops by about 20% as soon as the car is driven off the dealer’s lot. Subsequent years may see a lower rate of depreciation, but it’s still higher than for most items of personal property.
For the true market value of your automobiles, log on to National Auto Dealers Association or Kelley Blue Book. NADA also provides boat appraisals at boats.com. For other items such as jewelry or art, it’s best to get a professional appraisal, and be sure to deduct any costs that might be associated with selling the items.
Not everyone will be willing to go to the trouble of calculating a true net worth, but for those who like to be precise about such things, the effort will be worthwhile.
No need to worry if you prefer a more casual approach to calculating your own net worth, but keep in mind that you are more likely to overestimate the value of your belongings than underestimate.
How often should you determine your net worth? That depends on your personal preference. Some investors like to do the job monthly, while quarterly or even annually seems to be enough for others. No matter how often you do it, setting it all up on a computerized spreadsheet makes it easy to update on the schedule you choose.
Effective and profitable financial planning requires knowledge of where you stand. An accurate picture of your net worth is an essential part of that objective.
Have a question or comment? E-mail our editor Dave Davis at [email protected].