Calculating net worth realistically

Usually, when you calculate your net worth, you add up your stocks, house, and maybe newer cars, subtract mortgage and debt, and say "this is my net worth." That's great if you're trying to impress someone or qualify for a loan, but it doesn't really tell you what you could spend or invest with no other cash input. Why? Taxes and transaction costs.

Here's the traditional method:

• House: $600k


• Stocks: $100k


• 401k: $100k


• Newer car: $20k


• Cash: $5k


• Mortgage (no prepayment penalty): - $100k


• Credit card: - $5k


• Student loan: - $10k

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Assets: $300k+100k+100k+20k+5k = $525k
Liabilities: $100k-5k-10k = $115k
Net worth: $410k

But there's more to it than that.

It looks like the house is worth $500,000 free and clear, right? Not quite. If you sold that house for $600k and paid off the $100k mortgage, you won't walk away from the closing with a check for half a million dollars. The real estate agent will expect a check for 6%, or $18k. Other little garbage fees traditionally paid by the seller (which varies in different locales) can add another 2% or more. And that doesn't count the other little costs of selling a house - buyer concessions, a fresh paint job, bringing in a handyman for a day of minor repairs, cleaning carpets, putting half your "stuff" in storage, etc.

The stock and retirement account look healthy, too, right? Well, if you needed to tap the retirement account in a crisis, you'll pay regular income taxes plus a penalty (if you're under 59 1/2 years old). Even if you're in a state with no income tax and have such low income that you don't pay Federal taxes, the most you can spend from that retirement account is $90k ($100k balance minus 10% early withdrawal penalty). A California taxpayer earning enough to afford the median house would pay 53% in taxes and penalties on that retirement withdrawal.

The traditional method of calculating net worth really gives you "gross worth". It's quick and easy, but it excludes too many of the expenses that whittle away at the net.

Here's a more realistic assessment:

• House: $300k


• Transaction costs to sell house (8%): - $24k


• Tax on capital gains on house* ($300k-$250k exclusion= $50k taxable, 15% Fed, 10% state): $12k


• Stocks: $100k (Basis: $50k)


• Tax on Capital gains (15% Fed, 10% state): - $12k


• 401k: $100k


• Taxes on 401k withdrawals (25% Fed, 10% state, + 10% penalty): - $45k


• Newer car: $20k


• Cash: $5k


• Mortgage: - $100k


• Credit card: - $5k


• Student loan: - $10k
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Assets $300k+100k+100k+20k+5k = $525K
Liabilities: -$24k-12k-12k-45k-100k-5k-10k = -$208k
Net net worth: $317k

That's a difference of $93,000 in net worth. The first scenario overstates net assets by nearly 30%.

Tracking Net worth can help us track our progress towards financial independence. It can also help us figure out how much we can invest in a new business or a home. And it can give us peace of mind, knowing that we have sufficient assets to weather a crisis. Calculating it inaccurately, however, can lead to mistakes.

If we're tracking our progress, superficial net worth calculations can mislead us. Which is better? 10 half million dollar houses with $100k equity each, or a million dollars in stocks? The superficial net worth calculation says they're both equal. A liquidated or net net worth calculation reminds us that we'll pay ~8% transaction costs to sell those houses, leaving them worth $60k free and clear (each) if we sold them. In fact, housing can be the least profitable investment because you pay sales costs on the entire value, not just your equity and appreciation.

If we fund our retirement account without building a liquid asset account, the traditional net worth calculation will say that we're doing great. We think to ourselves "well, worse comes to worst, I have a hundred thousand in retirement." The truth is, withdrawing $100k from a retirement account can push you into the top tax brackets and Alternative Minimum Tax range, so more than half of the withdrawal would be lost to taxes and penalties. Perhaps thinking of it as a $100k balance worth $47k after expenses will help us keep an equal emphasis on funding a more liquid savings program, too.

Recognizing the liquidated or spendable value of investments can help us plan for retirement. A big, buff 401k balance is a beautiful sight to behold. But in retirement, it will be taxed as regular income. On the other hand, we could liquidate up to about $60k in capital gains every year (with no other income) and pay $0 in federal income taxes. Since you have a cost basis in stocks, $60k in gains could represent hundreds of thousands of dollars in actual sale proceeds. What a nice way to supplement your retirement without a big tax hit or losing social security benefits. Personally, I prefer a blend of tax-deferred retirement accounts and taxable savings and investments. This gives greater flexibility, hedges against rising taxes, and allows you to withdraw some savings penalty-free in a pinch. (Tomorrow I'll touch on legal protections for tax-deferred retirement accounts - you definitely want a blend of both.)

* Capital gains exclusion for single taxpayer is $250k on their primary residence. For a married taxpayer, the entire gain in this scenario would be tax-free. Still, taxes are only about half as much as the transaction costs.