Know Your Net Worth. Building wealth is all about making progress, and progress is measured against a starting point. Calculate your net worth today to figure out where you’re starting.
Calculate Your Net Worth Regularly. The only way to tell if your financial plan is working is to calculate your net worth regularly—such as every three months. If your 401(k) account is growing, but your credit card and home equity debt are also increasing, you may not be making progress. You may even be sliding backwards. Monitor your net worth to keep your financial plan on track.
Keep good records. Records are essential to keeping track of your finances and net worth. You can't build wealth without them. It's not terribly important whether you use electronic or paper records. Both have advantages and disadvantages. Do whatever works for you. The important thing is to make your personal recordkeeping system work. However, whether or not you like paper, keep in a secure place one paper document or a file of paper records that summarize your finances--where your accounts and other assets are, who your creditors are, and what passwords would be used for accounts that are electronically accessed. If you become mentally incapacitated or pass away, a paper summary is the fastest and easiest way for your family, a guardian or an executor to get a handle on your finances. In an emergency, without a quick summary like this, the money you need for medical care, or the money your kids need for this semester's college tuition, may be inaccessible and things could go wrong in a lot of ways.
The first step in building wealth is to figure out where you’re starting by calculating your net worth. You need to keep track of your net worth to tell if you are gaining or losing ground. As you gain ground, your enthusiasm for saving and investing will grow and your success will increase.
Your net worth equals your assets minus your liabilities. Since we are concerned with funding retirement, which takes financial assets, we will not count depreciating assets, such as clothing, computers, entertainment equipment (such as TVs and sound systems), and other consumer goods. The value of these goods will evaporate long before you retire. We will also not count cars as a financial asset, even though we’ll count car loans as a liability. This is because you have to pay the loan from your financial assets, but the car will depreciate as you pay off the loan. You don’t end up with much value from owning a car. (And if you lease, you won’t end up with any value.) It’s true that owning a car for a long time is financially beneficial, but that’s because you free up cash flow when you’ve paid off the car loan. If you save and invest the extra cash flow, you can build up your wealth faster. A car loan is no different than credit card debt you incur to buy a $3,000 monster screen TV—it has to be paid. That reduces the income available to fund your retirement, but doesn’t buy you an asset that increases your retirement savings.
Your financial assets include things such as cash, bank accounts, stock brokerage accounts, mutual fund holdings, real estate, retirement accounts like IRAs and 401(k)’s and insurance products that have investment value (such as annuities and whole life insurance). Term life insurance doesn’t count toward your net worth for retirement purposes (although you can count it toward whatever estate planning you're doing to protect your family). Collectibles such as coins, stamps, comic books, artwork and antique cars do not count in your financial net worth unless you are willing to sell them to fund your retirement. If you intend to keep your 1970 ‘Cuda convertible with the 426 cubic inch Hemi engine and your 1900 vintage Tiffany lamp until your dying day, they should not be included in your financial assets.
Liabilities are your debts. They include obligations such as mortgages, car loans, credit card debt, student loans, home equity debt and installment loans. You should include all forms of debt, including loans from family members and friends.
An example of a net worth calculation for retirement purposes follows. Assume you have the following assets:
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Next, let’s assume you have the following liabilities:
Liabilities Mortgage Home Equity Loan Student Loans Car Loans Credit Card Debt TOTAL LIABILITIES
NET WORTH
Accountants typically express negative numbers with parentheses, and this hypothetical example yields a negative net worth. If this were your true financial picture, you’d have room for improvement.
A more conservative way to calculate net worth would include the potential tax liabilities on the assets in your IRA and 401(k) accounts. If they are traditional IRA and 401(k) accounts, they would have been funded with pretax dollars, and you’d have to pay income taxes on the withdrawals you make (together with a 10% penalty if you withdraw funds before age 59 ½, although there are some circumstances in which the 10% penalty can be avoided). You might want to reduce the value of these accounts by the amount of the potential tax liabilities to determine their actual cash value to you. You’d have to guess what your marginal tax rates would be at the time of withdrawal, which may not be easy. But let’s assume that 1/3 of the value of the accounts would be taken by state and federal income taxes. That would reduce your net worth by another $6,833, resulting in a total negative net worth of $ (9,133).
If you have a Roth IRA or a Roth 401(k) account, you wouldn’t have to reduce it by potential tax liabilities since it is funded with after-tax dollars and withdrawals from it are tax-free if you’ve reached the age of 59 ½ and have held the Roth for five years. You can also withdraw the principal amounts deposited in them any time without penalty or further taxation. But if you withdraw any earnings or profits on the principal placed in the account before the five-year holding period or before reaching 59 1/2, you’ll have to pay both income taxes and a 10% penalty.
Calculate your net worth regularly.
Building wealth requires not just increasing assets, such as the value of your retirement and investment accounts, but also controlling the amount of your debt. If you’ve put a fair amount of your income into savings, but then borrowed heavily on credit cards and from your home equity to support a lavish lifestyle, you may be going nowhere fast. You may even be sliding backwards. You won’t know which way you’re going unless you regularly calculate your net worth. Every three months (e.g., on January 1, April 1, July 1, and October 1) would be a good interval.
Keep good records. Keep your monthly statements (from banks, mutual funds and brokerage firms, as well as credit card issuers and the mortgage company) for a year or two, or ensure that you have good online access (so that you can go back a year or more if necessary). If you are tech-inclined, use personal finance software to keep track of where you are. If you are computer-averse, use paper (if you're concerned about tree mortality, use recycled paper). Keep the basic information about your finances on paper somewhere secure--where your accounts (including regular and retirement accounts) are, the account numbers, passwords for electronically accessed information, the location of any physical assets like safe deposit boxes or the vacation home out of state, and who your creditors are. If something happens to you, a paper summary of your financial situation will be the fastest and easiest way for someone else (your family, guardian, or executor) to get a handle on your finances. If everything is in a hard drive or online somewhere, the person who takes over for you may not be able to find the information and may not have the passwords necessary to access it. Your hard-earned financial wherewithal could become an instant mess simply because no one else can get access to your financial information.
Be financially aware—monitor your spending, saving, borrowing and net worth.
Like anything else, people who think about their financial situation and focus on their finances usually end up better off than those people who focus on other things. If you were physically ill, you wouldn’t expect to recover unless you focused on the illness and took care of yourself. If you are financially ill, you can’t expect to recover unless you take care of your finances. The good news is that most people can recover from financial problems if they put their minds to it.
If you don’t know your net worth, calculate it now. Once you know where you stand, move on to our discussion of getting Control Over Your Money.