Steve at Wealth of Geeks has written this interesting post on net worth and how closely it’s tied to your plans for retirement.
Picture retirement in your head. What does it look like? Are you sitting on the beach sipping cocktails, sunk deep into a comfy sofa in a cozy mountain cabin, or walking to nearby restaurants from your apartment in the big city?
Retirement will look very different for all of us. And one of the most significant factors in how we will retire is our net worth. Our net worth is a relatively simple calculation of assets and liabilities.
The result is what we are financially “worth.” The higher our net worth, the more comfortable our lifestyle will be after calling it quits from full-time work.
Your net worth has a significant impact on your life and retirement. Here’s why.
How Net Worth is Calculated
It might seem complicated, but the net worth equation is quite simple. Net worth is calculated by subtracting one’s total liabilities from total assets. The resulting number is our net worth.
What are assets? Assets are things that we own that have value. For instance, cold hard cash and investments in the stock market are considered assets.
Real estate holdings (like houses or land) and precious metals are assets. These things are assets because they have a monetary value. They can be sold for money.
Liabilities are debts or other financial obligations. Examples of liabilities include mortgages, credit card debts, outstanding bills, and car loans.
Your total liabilities are your “accounts payable” ledger in typical accounting terms. It’s money that we owe to someone else.
The best way to understand how net worth is calculated is by looking at an example.
Suppose Sally owns a primary residence valued at $400,000. In addition, she has another $250,000 in the stock market and a gold coin collection worth around $30,000. In total, Sally has $680,000 in assets:
400,000 + 250,000 + 30,000 = 680,000
Sally also has $225,000 left on her mortgage and a $12,000 car loan. In total, Sally has $237,000 in liabilities:
225,000 + 12,000 = 237,000
To calculate Sally’s net worth, you would use this simple equation:
680,000 (assets) – 237,000 (liabilities) = $443,000 (net worth)
Sally is worth $443,000.
Note that net worth can be negative (below zero). Negative net worth happens if liabilities total more than assets. Early in life, having more liabilities than assets is not uncommon.
However, a negative net worth late in life can have severe consequences, such as significant delays in retirement or a lower quality of life.
Why is Net Worth Important?
Your net worth has a direct impact on your retirement.
Once the steady paychecks from a full-time job stop (typical in retirement), we are forced to live off the money we’ve saved and invested throughout our careers.
Knowing your net worth gives you a good idea of how close you are to retirement.
A long-standing study from Trinity University found that most of us can spend about 4% of our net worth with a reasonably good chance of never running out of money.
Of course, this number assumes most assets are invested (rather than sitting in a checking account or hidden under a mattress). But, coupled with your average yearly spend rate, you can use this 4% guideline to estimate when you have accumulated enough money to retire.
For instance, let’s assume you have a net worth of $1,000,000. Using the guideline from the Trinity Study, 4% of a million is $40,000. This means we can probably spend around $40,000 a year in retirement without running out of cash.
Another way to use the Trinity guideline is to multiply your current yearly spending rate by 25. The resulting number will be the net worth that you should have before calling it quits.
For example, if you spend $60,000 a year, you should have a net worth of $1,500,000 to safely retire without ever worrying about money again.
60,000 x 25 = 1,500,000
Note that the Trinity 4% guideline is just that…a guideline that can help you when preparing for retirement. It’s not a rule. There are no guarantees in life.
How To Increase Your Net Worth
A higher net worth means we have more money saved and invested. That money can help us live a more comfortable life after our working days are over. In some cases, a high net worth might allow us to retire much sooner than we thought possible.
In order to increase your net worth, two things need to happen:
- Boost your assets, and
- Reduce your liabilities
You can boost your income in any number of ways. Asking your boss for a raise or a promotion is a great way to increase your income. Investing that income will help to boost your net worth. Or, consider starting a side hustle on the weekends to earn more money.
Reducing your liabilities will limit the amount of money you owe to other people (i.e., credit card debt, big mortgages, etc.). As a result, lower debt means higher net worth and a most stable financial life.
The Bottom Line
Your net worth profoundly affects your life and retirement. The higher your net worth, the sooner you will be able to retire. If your net worth is negative, make getting out of debt your top priority. Believe me, your retirement will thank you.
Featured image credit: Unsplash.