How the Standard Formula for Net Worth Overstates Your Wealth—and How to Fix it

You’ve worked hard. You’ve avoided debt. You’ve saved and invested.

Through the years, you’ve regularly updated your net worth using the standard formula:

Assets – Liabilities = Net Worth.

According to this calculation, you’ve made substantial progress. The stock market’s done well and so have you.

But if you’ve only been looking at your net worth statement you haven’t seen a complete picture of your available wealth.

Here’s the problem.

As typically calculated, net worth provides a snapshot of current finances. Importantly, it’s not designed to show the burden of future liabilities. The formula’s myopic focus on present value hides some important realities.

For example, assume that years ago you bought Exxon stock for $20,000 and that its value has since quintupled to $100,000. Without question, this asset’s present value for purposes of your net worth statement is $100,000.

But what about the taxes you owe on your $80,000 profit?

Under the standard approach to net worth taxes don’t enter the picture until the asset is sold. So although your Exxon profits are destined for taxation as long term capital gains, until those taxes are actually incurred your appreciated stock is valued at its current market price without any offset. Of course, this limited portrait of net worth fails to show the taxman who lurks just out of view.

Let’s further explore the shortcomings of the standard net worth formula with a made-up example.

Using the accepted approach to calculating net worth, this chart describes the good fortune of John and Jane Dough, a hypothetical married couple in their late 40’s.

Net Worth of the Dough Household: November 13, 2017

# Assets Value
1 Checking $4,000
2 Savings $1,000
3 Brokerage # 1 $150,000
4 Brokerage # 2 $50,000
5 HSA # 1 $4,000
6 HSA # 2 $4,000
7 Roth # 1 $5,000
8 Roth # 2 $5,000
9 Main residence $300,000
10 Vacation home $300,000
11 401k $700,000
12 Trad’l IRA # 1 $230,000
13 Trad’l IRA # 2 $200,000
14 Antiques $47,000
Totals $2,000,000

As the chart reports, the standard net worth formula places the Doughs’ wealth at a whopping $2 million. According to this glowing picture of their financial life they live in a sunny utopia.

But consider what lurks in the nearby shadows.

High Income Taxes. As a dual-income couple, the Doughs qualify for the 25 percent federal tax bracket. What’s more, they live in a state that gleefully taxes their income at a hefty 9 percent. The combined marginal rate of 34 percent has put a big dent in their take-home pay during their working years. The pain will continue after they retire because withdrawals from tax-deferred accounts are taxed as current income. Post-retirement, they will likely remain mired in the 34 percent bracket as they both collect Social Security and access their ample 401k and Traditional IRA accounts (lines 11-13).

Capital Gains on Stocks and Real Estate. The Doughs’ assets have appreciated since their original purchase. The stocks in their brokerage accounts (lines 3-4), which were acquired years ago for $100,000,  are now worth $200,000. Their vacation home (line 10) has also doubled in value during their two decades of ownership. These assets denote substantial wealth, but the Doughs can’t tap that wealth without incurring long term capital gains taxes (15% federal + 9% state = 24% combined).

Taxes on Collectibles. The antique collection (line 14), which was assembled in the 1990’s for a mere $10,000, is now worth $47,000. The feds tax profits from the sale of these collectibles at 28 percent; the state tacks on 9 percent (combined tax = 37%).

Sales Commissions and Closing Costs. When the Doughs sell one or more of their houses (lines 9-10), the busy couple will discover that the real estate can’t be unloaded without paying realtors (6% is customary) and closing costs (about $3,000 per property). Likewise, the antiques (line 14) won’t fetch the best prices without them hiring expensive auctioneers or consignment shops (25% for either).

In short, the Doughs’ net worth statement overlooks: (1) future taxes; and (2) future asset sale costs such as broker commissions and closing fees.

This updated chart captures what is missing from the standard formula of net worth.

Net Worth of the Dough Household (Modified): November 13, 2017

# Assets Value Fed Rate State Rate Projected Tax Sale Costs Net Value
1 Checking $4,000 $0 $0 $4,000
2 Savings $1,000 $0 $0 $1,000
3 Brokerage # 1 $150,000 15% 9% -$18,000 -$100 $131,900
4 Brokerage # 2 $50,000 15% 9% -$6,000 -$50 $43,950
5 HSA # 1 $4,000 0% 0% $0 $0 $4,000
6 HSA # 2 $4,000 0% 0% $0 $0 $4,000
7 Roth # 1 $5,000 0% 0% $0 $0 $5,000
8 Roth # 2 $5,000 0% 0% $0 $0 $5,000
9 Main residence $300,000 0% 0% $0 -$21,000 $279,000
10 Vacation home $300,000 15% 9% -$30,240 -$21,000 $248,760
11 401k $700,000 25% 9% -$238,000 $0 $462,000
12 Trad’l IRA # 1 $230,000 25% 9% -$78,200 $0 $151,800
13 Trad’l IRA # 2 $200,000 25% 9% -$68,000 $0 $132,000
14 Antiques $47,000 28% 9% -$9,343 -$11,750 $25,908
Totals $2,000,000 -$447,783 -$53,900 $1,498,318
Amount NW Formula Overlooks: $501,683
Percentage NW Formula Overlooks: 25.08%

For the Doughs, future taxes and liquidation costs impose a $500,000 hidden burden—an astounding 25 percent hit to their stated net worth. Without question, this is bad news. But there’s a silver lining. All the financial pitfalls disclosed in this future-looking chart are actionable.

Indeed, anyone can use this type of analysis as a springboard for diving into their own financial planning. The exercise of identifying future taxes and liquidation costs, however depressing, can produce enormous savings. With just a little advance planning, anyone can avoid handing over truckloads of currency to zealous taxmen and commission-hungry agents.

Strategies abound for dealing with future taxes and liquidation costs. Here are a few the Doughs might choose from, especially if they’re willing to pursue an earlier-than-normal exit from the workforce.

Slip into a 15 Percent Bracket. If either or both of the Doughs retire early, this could reduce their income enough to drop them into the 15 percent federal tax bracket. Taxpayers in this bracket pay no taxes on capital gains. This move alone could save the Doughs $15,000 in projected federal taxes as they take a few years to sell off their appreciated stocks (lines 3-4).

Sell the Primary Residence and Move into the Vacation Home. With early retirement comes greater freedom to relocate. Since the Doughs have lived in their main home for two of the last five years, as a married couple they can sell it and avoid capital gains taxes on up to $500,000 of profits. Then they can move into the vacation home, live there for two years, and repeat the same process for another tax-free sale. This move could avoid $30,240 of future capital gain taxes that now cloud the stated value of their vacation home (line 10).

Track all the Cost of all Improvements to the Vacation Home. If it isn’t practical for the Doughs to move into their vacation home, they should at least keep a strict accounting of all amounts they pay for improvements. When it comes time to sell, these documented increases to their asset’s tax basis will decrease their capital gains tax (see line 10).

Relocate to a State with Lower Taxes. With no full-time job tying them down, the Doughs have more choices about where to live. If they eventually move to a jurisdiction with no income taxes, they can avoid their local 9 percent rate and save up to $101,700 in state-based taxes as they draw down their 401k account and Traditional IRAs (lines 11-13).

Pursue Roth Conversions. Subject to various rules, the IRS permits taxpayers to transfer money from Traditional IRAs into Roth IRAs. This process is known as a “Roth Conversion.” By retiring early and feathering money each year into their Roth accounts, the Doughs can avoid much of the federal taxes they would otherwise pay on withdrawals from tax-deferred accounts (lines 11-13). Potential savings: up to $282,500.

Fund HSA Accounts. Health Savings Accounts represent a terrific tax break because they offer three different levels of tax savings: (1) deposits are deductible; (2) earnings  grow tax-free; and (3) withdrawals aren’t taxed if they’re used to pay qualified medical expenses. The Doughs’ HSA accounts (lines 5-6) are underfunded. By contributing the maximum allowed each year, the Doughs can greatly improve their post-retirement prospects.

Hire Flat-Fee Real Estate Brokers or Pursue FSBO. By retiring early, the Doughs will have ample time to market and sell their own real estate, a process known as “For Sale By Owner” or FSBO. Alternatively, they can hire a real estate agent who works for a flat fee. Adopting either strategy will save up to $36,000 in broker commissions (lines 9-10).

Learn to Sell Antiques. With more time on their hands, the Doughs can dive deeper into their antique hobby. As they network, they can locate buyers on their own and bypass expensive middlemen (line 14). Savings: $11,750.

If these strategies are implemented, the Doughs can preserve most of their imperiled $500,000 from the grasping claws of taxmen and sales agents. This final chart reports their potential savings.

Net Worth of the Dough Household (After Financial Planning): November 13, 2017

# Assets Value Fed Rate State Rate Projected Tax Sale Costs Net Value
1 Checking $4,000 $0 $0 $4,000
2 Savings $1,000 $0 $0 $1,000
3 Brokerage # 1 $150,000 15% 9% $0 -$100 $149,900
4 Brokerage # 2 $50,000 15% 9% $0 -$50 $49,950
5 HSA # 1 $4,000 0% 0% $0 $0 $4,000
6 HSA # 2 $4,000 0% 0% $0 $0 $4,000
7 Roth # 1 $5,000 0% 0% $0 $0 $5,000
8 Roth # 2 $5,000 0% 0% $0 $0 $5,000
9 Main residence $300,000 0% 0% $0 -$4,000 $296,000
10 Vacation home $300,000 15% 9% $0 -$4,000 $296,000
11 401k $700,000 25% 9% -$70,000 $0 $630,000
12 Trad’l IRA # 1 $230,000 25% 9% $0 $0 $230,000
13 Trad’l IRA # 2 $200,000 25% 9% $0 $0 $200,000
14 Antiques $47,000 28% 9% -$10,360 $0 $36,640
Totals $2,000,000 -$80,360 -$8,150 $1,911,490
Amount NW Formula Overlooks: $88,510
Percentage NW Formula Overlooks: 4.43%

A big improvement! The $501,683 that was previously subject to future taxes and transactional fees has been cut to a mere $88,510. The total gain from the Doughs lucrative foray into financial planning: $413,173. Solid proof yet again that it really pays well to really pay attention.

*   *   *

The standard net worth statement is a great tool for marking progress as you grow your wealth. But it obscures from view the corrosive effects of future taxes and transactional costs. If you can spot these future expenses now—instead of waiting to stumble upon them later—you’ll give yourself the time it takes to sidestep these drains on your financial wellbeing.

Keep on saving!

photo: endinburghcityofprint

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10 Responses to How the Standard Formula for Net Worth Overstates Your Wealth—and How to Fix it

  1. Fran November 13, 2017 at 5:29 AM #

    Fantastic analysis. Never thought this way about the “too simple NW calculation.” I stopped working at 61 and husband has a bit more than one year to 65. Definitely will be looking at our real NW. In addition, the tax bills being kicked around congress right now add so much more uncertainty to the mix.

    • A Noonan Moose November 13, 2017 at 9:15 AM #

      It’s good to focus on taxes well before the required minimum distributions kick in as each of you reach age 70.5. With some advance planning you may be able to keep more money for yourselves and send less over to the federal and state governments. Thanks for commenting Fran!

  2. Jody Foster November 13, 2017 at 5:51 AM #

    Are lines 12 and 13 correct? It seems like you are taking out federal taxes and state taxes, but I only see reference to avoiding state taxes in the text. Thank you!

    • A Noonan Moose November 13, 2017 at 9:43 AM #

      Lines 12-13 are correct. The 9% state income taxes are eliminated by a move to a state that doesn’t impose income taxes. The projected 25% federal income taxes are reduced by two strategies discussed in the text: (1) pursuing a multi-year program of Roth conversions; and (2) slipping into the 15% tax bracket upon early retirement (this will happen in large part because the required minimum distributions from the Doughs’ tax-deferred accounts will be much smaller thanks to years of Roth conversions). These strategies will not eliminate federal taxes completely on the tax-deferred accounts. As you can see, line 11 projects that $70,000 will still be paid in federal income taxes on the 401k. For some further background about Roth conversions, specifically about my own household’s ongoing multi-year use of Roth conversions, see Section 5 of this article.

  3. Jody Foster November 14, 2017 at 5:40 AM #

    Thanks for the link to your other article. I didn’t realize how you were pushing the federal tax on the conversions towards $0 by converting slowly.

    • A Noonan Moose November 14, 2017 at 11:09 AM #

      Jody–thank you very much for commenting!

  4. Douglas C. November 15, 2017 at 6:13 AM #

    Thank you for yet another excellent, extremely well-written post. Over the years I’ve applied various ballpark ‘future liability’ discounts to our NW figure, and had settled on 25%, interesting to see this confirmed in your thinking. Your analysis of avoidance strategies is extremely useful, I really need to do a projection for the “Roth feathering” strategy.

    • A Noonan Moose November 15, 2017 at 9:35 AM #

      Douglas–thank you so much for the encouraging words! I have a draft article in the works that provides details about our multi-year Roth conversion strategy. I will do my best to post it before year’s end. Thanks again for commenting!

  5. Hélène Massicotte February 4, 2018 at 7:54 PM #

    This is exactly the type of content that has me coming back. How refreshing to see someone:

    1. Acknowledging and then spelling out the tax implications for the various assets that make up one’s NW

    2. Offering suggested actions that could significantly minimize the default tax exposure for each listed item.

    The topic is on point and well written, as always.

    • A Noonan Moose February 5, 2018 at 9:18 AM #

      I am all ablush—thanks so much Hélène!

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