Imagine that you have just landed in an unfamiliar city and now have to drive your rental car to your hotel. Do you want a car with GPS navigation that tells you which streets to take, or do you just want to wing it and drive around until you find the place? Seriously, how hard could it be to find your way around Hong Kong, right? The net worth calculation is like GPS for your retirement savings. It tells you where you are now, and gives you an idea of what you need to do to get to your destination.
In this article we will show you how to calculate your net worth and then explore how you can use this calculation to keep your retirement plans moving in the right direction. (For related reading, check out Will Your Retirement Income Be Enough?.)
How To Calculate Your Net Worth
Net worth is simply the amount by which assets exceed liabilities. It's a concept that can be applied to companies and to individuals and serves as a benchmark for measuring financial health. Calculating your net worth is easy. The formula is simply:
Net worth = Assets - Liabilities
With that as you starting point, it's time to figure out your net worth. To do this, you will need to calculate your assets and your liabilities.
- Determining Assets – Liquid assets are simply those that can be turned into cash quickly. Bank accounts, certificates of deposit, stocks, bonds, mutual funds and similar investments fall into this category. Illiquid assets, such as your primary residence and other real estate holdings, also count, as do assets in your 401(k) plan and partnerships in businesses. All of these items should be included in your calculations. Personal property, such as jewelry, vehicles and clothing should be excluded. These items may cost a lot to acquire, but are likely to be worth little from a resale perspective. (To learn more, read Keeping Track Of Retirement Plan Assets.)
- Determining Liabilities – On the other side of ledger are your debts. Credit cards, car loans, home mortgages and business loans all fall into this category. The liability side of the equation is particularly interesting because this is where most people get in trouble. Lifestyle-related factors, such as a person with a low income but frugal spending habits or a person with a high income but higher spending habits can skew the net-worth calculation. (If debt is a problem for you, check out Digging Out Of Personal Debt and How to Invest When You're Deep In Debt.)
Where Do You Stand?
Mitigating factors play a major role. A college education versus a high-school education generally has a doubling effect on a household's net worth. Being self-employed versus working for an employer can triple net worth. Living in the Northeast versus the South nearly doubles net worth.
Because of these mitigating factors, net-worth calculations are not universal in terms of their usefulness as a benchmark. These factors must also be taken into consideration when making comparisons against the national averages (Figure 1).
|Age of Head of Household||Median||Mean|
Consider, for a moment, geographical disparities in the United States. It costs more to live in the North than in the South, less to live in the middle of the country than on the East or West Coast, and more to live in a city than a small town, etc., so net-worth calculations need to factor in lifestyle. A million dollars in Mississippi is not the same as a million in Los Angeles.
In the next section we will look at ideal net worth and how to use this calculation as a road map to retirement planning.
The Ideal Number
How much should you be worth? Every individual has his or her own unique lifestyle, so there is no one-size-fits-all, universally agreed-upon number. That said, Thomas Stanley and William Danko, authors of "The Millionaire Next Door" (1998), provide a general formula:
Net worth = Age * Pretax income ÷ 10
Using this formula and a basic salary of $25,000, we get the following results.
Right now the numbers obviously look a little bizarre. Finding a 20-year-old (especially one going to college) with a net worth of $50,000 may not be impossible, but most gamblers would bet against it. At the other end of the spectrum, finding a 70-year-old homeowner with a net worth of $175,000 isn't particularly difficult, particularly in areas where real estate has appreciated significantly over time.
Since few professionals work their entire lives without getting a raise or a better job, factoring in rising income dramatically changes the numbers. Consider the following:
In both cases, the estimates are high for young workers. In the steady-income scenario, the estimate is particularly low for a worker approaching retirement age. Still, the numbers provide a benchmark for consideration. If you are doing better than the benchmark, you are least moving in the right direction. Interestingly, under the scenario where income rises with age, the net-worth estimate delivers results similar to those generated by a formula put together by David John Marotta, a widely-quoted financial advisor.
Marotta recommends instituting a savings plan that results in building net worth to the point where it reaches 20-times annual spending by the time a person reaches age 72 and retires. Under this plan, the older you get, the more you need to save. Ideally salary increases with age. So, by these calculations we can put together a fairly accurate measuring stick to compare your net worth against.
vs. annual spending
|Annual Spending||Net Worth*|
Building Your Net Worth
While the theoretical formulas and the national averages provide some insight into the issue of net worth, absolute truths are harder to find. At the basic level, having a positive net worth is preferable to a negative net worth and having a higher net worth is better than having a lower net worth.
If your net worth is negative, strive to get it on the positive side of the ledger. While a low income makes it harder to build your net worth, if the numbers come up negative, spending is the culprit. Cutting your spending is the first step toward turning your situation around. Paying off debts is the next. If your net worth is low, strive to build it through saving and investing. Focus on maximizing the amount you save and minimizing the amount you spend.
If your net worth is high, keep building on your momentum. The amount that you have saved may enable you to change your lifestyle, providing enough money to travel during retirement or engage in hobbies that you could not afford during your working years. Work to save enough to fund the specific lifestyle that you desire.
To get started, check out Enjoy Life Now And Save For Later.