Net worth is the difference in a simple subtraction problem: the dollar value of all assets minus the dollar value of all liabilities. Despite the ease of the concept, disagreements about what should “count” towards net worth trigger consistent debate among individuals interested in finance. Much of this debate comes down to the liquidity of certain assets considered when calculating net worth.
In finance, liquidity refers to how accessible money is. The more “liquid” an asset, the more readily it can be used. Cash is the most liquid asset since you can immediately use it to go buy an ice cream treat without any additional logistics. On the other end of the spectrum are assets like real estate. Your home may be paid off and worth $1 million, but you would probably need around 45 days for a sale to go through even if you had a buyer lined up today. Real estate is generally considered quite illiquid since many logistics go into turning the asset into money that you could use to purchase something else.
Most assets fall somewhere in between. Your high-yield savings accounts are a little less liquid than cash but probably quite liquid. It may take a day or three to transfer some funds from a HYSA to a checking account, but they generally get there quickly. Other assets are a bit more complicated. Parts of a Roth IRA are as liquid as a HYSA, but others are illiquid or require a significant fee to liquidate them. Since your actual contributions to a Roth IRA can be withdrawn whenever you want, they are immediately fairly liquid. However, the growth in a Roth IRA is unavailable until age 59.5, making it quite illiquid for a young investor without realizing a loss due to early withdrawal fees.
Some investments may be even more illiquid than real estate. A private equity investment where you sign away money for 3 to 5 years with the hope of a large payout can lock your money away for years without a contingency option. A unique piece of artwork that can only be sold to interested high-net worth art collectors may be unsellable at any given time since the number of buyers is limited. Even real estate has different realized levels of liquidity: The most expensive pieces of real estate have fewer potential buyers than those with more average home prices, making it less probable that they will sell in a timely manner.
Liquidity Tradeoffs
Having some liquid assets is important. Having money in case of an emergency can put your mind at ease and prevent a financial (or other) catastrophe. But having too many liquid assets comes with a downside.
The most liquid assets generally experience no to low growth. If you only have relatively liquid assets, you will not experience the full potential of wealth accumulation possible with long-term investments. On the other hand, if all your assets are illiquid, you cannot adequately react to a small emergency, like repairing a car after a minor accident.
Liquid money can be used quickly, but illiquid money has a much higher potential for growth. When considering your assets, having both is ideal. Have enough liquid assets to cover probable expenses and an emergency, and invest everything else to allow maximum wealth accumulation.
Net Worth Arguments Concerning Liquidity
Liquidity factors into net worth debates because some individuals argue that illiquid assets should not be included in net worth calculations. The justification for excluding illiquid assets from net worth usually centers around the fact that these assets cannot be quickly or reliably exchanged for cash or purchases, so it is not useful to include them in net worth assessments.
But not being able to sell something quickly does not mean that you cannot sell it. Particularly since illiquid assets have a higher ceiling for appreciation, excluding them from your net worth calculation altogether seems imprudent.
To reconcile these two ideas we split the difference. We calculate our liquid net worth, which includes all of our financial accounts from which we could theoretically withdraw. We also calculate our total net worth, which at the moment is our liquid net worth plus the equity in our home.
While some folks may also include assets like cars, we consider our car a simple transportation device that we plan to use until it no longer works. For primary vehicles, and secondary vehicles in larger families or families that need to drive frequently, it is probably best to not include them in your net worth. However, if you have a car that you use sparingly at most and primarily own it as a collector rather than a functional item, it may be worth including in your net worth. The same concept goes for anyone lucky enough to own other methods of transportation: Your cute paddle boat that you use everyday in the summer is probably not worth including in your net worth, but your luxury yacht probably is since you likely spend on its upkeep.
There is no perfect line between what to include versus exclude in your net worth. Our approach is to include anything that we plan to spend/sell or anything that we plan to maintain with the upkeep that we could sell it. We do not include the car we plan to use, the baseball memorabilia we plan to keep, or the rings we wear.
The liquid versus illiquid line is similarly fuzzy. We consider pretty much everything liquid since our mindset revolves around considering what we can spend when we retire. Since we are not looking to spend our Roth IRA money now, it does not matter to us that a certain percentage is inaccessible until we are older. Our home is the exception because we live here and are not planning to sell that in retirement, even though it is possible that we would.
Liquidity Implications on FIRE
Our approach to liquidity vs illiquidity hinges on our FIRE perspective. In our view, we need to hit our FI Number excluding the value of our home since we do not plan to sell our home when we retire. Our liquid net worth is the money we could use to live in perpetuity in early retirement.
If you are separating portions of your net worth with considerations of what money you can use for early retirement, you may also need to consider what money is available to you before age 59.5 versus which money you can use in later retirement. Accessing money before regular retirement age can be tricky if all or most of your investments are in retirement accounts like 401(k)s or IRAs.
We do not worry about the accessibility of our money too much for a couple reasons. First, we also consistently invest in a brokerage account after maximizing contributions to our retirement accounts. We can use all of the money in our brokerage accounts before turning 59.5 since the money in our retirement accounts will still enjoy the growth of compound interest untouched. In other words, we will withdraw part of the principal of brokerage accounts while not withdrawing the growth on retirement accounts. While this sounds like a deviation from the standard do-not-touch-the-principal approach to FIRE, it has the same impact on overall net worth.
We also have most of our retirement money in Roth IRAs and a Roth 401(k). Roth accounts allow you to withdraw your own contributions penalty and tax free (because you already paid taxes on the accounts) prior to age 59.5. Like with the brokerage account, withdrawing the contributions still allows the growth on these retirement accounts to accumulate compound interest, growing considerably prior to retirement. If you do not have many assets in Roth accounts and are planning for early retirement, consider a Roth conversion ladder for your traditional retirement assets.
Finally, we have a successful business in our corner that has already provided our early retirement with a slow rollout to reduce risk. Patrick already left his day job to become a full-time entrepreneur. When I do the same, we still will have a business that can cover our annual expenses while we figure out the best way to scale down and withdraw our assets. Having multiple streams of income and letting them go one-by-one removes a lot of pressure for your investments to hold up against market fluctuations in the first couple years of early retirement.
If you are pursuing FIRE, it is important to base your FI Number off of only the assets that you actually plan on using to sustain yourself. If you are keeping your home, your boat, and your sports car, do not use these assets to calculate the net worth relevant to your FI Number. If you plan to sell your home and travel full time, you can count it towards the net worth for the purposes of your FI Number. Your specific situation is what determines what counts.
How much you need to consider whether money is accessible before age 59.5 also depends on your plans. If you are slowly rolling out your eventual retirement, you probably do not need to worry. If you and a spouse have high-paying 9-to-5 jobs, no other streams of income, and plan to leave those jobs at the same time, you probably need to work out a plan of when you will use different accounts to fund your life. Another consideration is how far you are from regular retirement. If you retire at age 55, technically early but within five years of regular retirement, you will almost certainly get to age 59.5 spending your Roth contributions, doing a Roth conversion ladder on some of your traditional contributions, or using the “Rule of 55” to bridge the gap. A 30-year-old retiree must think a lot more about how to bridge the nearly thirty years until regular retirement.
You may see debates about what counts and does not count when calculating your net worth. Ultimately, you need to be able to calculate the numbers that allow you to make informed decisions about your financial future and retirement. Do not worry about whether someone else includes their primary residence or boat in their net worth calculations. Calculate your net worth in a way that allows you to know your options.
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