What exactly is meant by “liquid net worth”?
In How to Figure Out Your Real Net Worth, I explained what net worth is and how to figure it out. But there is more than one measure of financial success.
What we discussed in that essay might be loosely referred to as total net worth. Net worth that can be quickly converted into cash is a more precise measure.
It uses the same basic formula for determining total net value, but it also accounts for the costs and other considerations inherent in transforming intangible assets into liquid ones.
The difference between total net worth and liquid net worth exists because of this.
Why is it the case?
This is the reason why having a liquid net worth is so important:
While net worth is a number that can make a person feel good because it is an optimum number. Taking the total value of your assets and deducting your total debts will give you your maximum net worth.
Having a high proportion of your net worth in liquid assets is important because it indicates how quickly you could get access to that money if you had to liquidate your assets.
Whole net worth is determined by the following formula, which I detailed in How to Determine Your Real Net Worth:
Assets – Liabilities = Net Worth
Yet, your genuine net worth is only your liquid net worth if your assets are not retained in illiquid form. This is so because it will factor in any and all expenditures associated with liquidating the business.
Differentiating Between Total and Expendable Wealth:
Your net worth is $200,000 if your assets have a gross value of $500,000 and your total liabilities amount to $300,000. Nonetheless, your liquid net worth will be smaller than what you initially thought.
Suppose, for instance, you had to sell all you owned to pay for an expensive medical procedure, to aid a struggling relative, or to launch a new business. It’s possible that you won’t get the full market value for the assets you’re selling off because you’ll need to liquidate them so rapidly.
You could, for example, drop the asking price for your home by ten percent if you needed to move it quickly. You could use the proceeds from the sale of a second vehicle or a vacation property in the same way.
When selling property, you’ll additionally need to account for transaction fees. It’s the same when you’re selling stocks or bonds.
If you had to sell everything you owned to cover a sudden bill, your liquid net worth would be the only criterion.
It’s Time to Get Begin:
With every sale of assets that cannot be immediately converted into cash, transaction expenses must be considered. And depending on how quickly you need to sell an asset, the amount you may have to discount it for a speedy sale will vary.
Your total assets of $500,000 would be reduced to $420,000 if you had to take into account a discount of $50,000 and liquidation expenses of $30,000. Your current net worth is $120,000 after removing your $300,000 in debts.
Influencing Elements of Easily Accessible Wealth:
Depending on the specifics of each investor’s portfolio, these considerations will take on varying levels of importance.
Your liquid net worth will be much lower, for instance, if most of your assets are in real estate or retirement savings rather than cash and cash equivalents.
Each type of investment has its own specific liquidation considerations.
Inherently Floatable Assets:
Money and other liquid assets fall under this category. This can be seen in:
- Stockpile of liquid assets
- Banking services including checking and saving
- In the money market
- Securities backed by a bank’s faith and creditworthiness (CDs)
This is because there are no costs associated with liquidating these assets and their market worth will not be affected in any way.
But, if you cash in a certificate of deposit before its stated term is over, you will likely be subject to a nominal prepayment penalty.
Pensions and Annuities:
Among people’s possessions, the value that retirement plans add to their liquid net worth is the most likely to be misinterpreted.
Many consumers wrongly believe that a 401(k) account balance of $200,000 boosts their wealth by the same amount.
Never hold such a belief, at least not when discussing readily available assets.
Income tax is the reason why. Benefits from retirement plans can be delayed indefinitely but are still subject to taxation. In the event of an immediate need to withdraw funds from a 401(k) plan, the withdrawn amount will be subject to ordinary income tax. There is typically a 10% early withdrawal penalty if you take money out of your retirement account before you are 59 and 12.
If your federal and state marginal tax rates on income are both 20%, you’ll owe 30% of the plan’s value (plus the 10% penalty) upon liquidation. An individual with a $200,000 plan would only have $140,000 after paying taxes.
Commissions on the sale of assets held in the plan and liquidation fees owed to the plan administrator are also possible. That could reduce the value of your plan by a few thousand dollars more.
Roth IRAs are the one and only exception, but only if you’re over 59 12 and have contributed to the plan for at least five years. In that case, you can cash out your entire plan without paying any tax or penalty. Under the terms of the plan, you stand to receive the whole sum of $200,000.
You will be subject to regular income tax and the 10% early withdrawal penalty on the investment earnings component of your Roth IRA if you take money out of it before you turn 59 12.
Real Estate:
Real estate is likely the most convoluted asset when it comes to liquidating. It can take a number of weeks to sell a house, even in a healthy real estate market. But, if the market is slow, it may take a few months.
It all comes down to how quickly you need to sell it, though, when determining how much you can ask. If you’re in a hurry to sell, you’ll need to lower the price below what the market will bear. If you need to sell fast yet the house is worth $300,000, for example, you could have to reduce the price to $280,000 or $270,000.
If you are willing to wait as long as necessary to sell, you can expect to receive the current market value.
Property Transfer Fees:
Yet, there are transaction costs to consider in addition to those influenced by market forces. They are sometimes prohibitive in cost.
The standard commission for a real estate agent when selling a home is 6%. A provider that offers to sell it for significantly less is easy to find, but the quality of service they give may suffer as a result. That probably won’t help you sell fast if you need to.
Yet, there are additional expenses that must be considered in addition to a real estate sales commission. Closing expenses are often estimated to be between one and two percent of the total loan amount. The attorney fee, state sales tax, and other seller costs vary by jurisdiction and market.
Seller-paid closing fees are another possibility, depending on the local real estate market. Closing cost assistance can be a powerful incentive for potential buyers to submit an offer on your house. Yes, that’s the best part.
The bad news is that you’ll have to shell out real money for those closing expenses. That’s another two to three percent of your home’s selling price.
The total amount you spend on selling your home could be close to 10%. Even if you have no plans to sell your house in the near future, its fair market value should be subtracted from your liquid net worth when doing a personal financial assessment.
Commercial Purposes:
It might be complicated to factor in ownership of a firm when calculating personal wealth. Even in the best of conditions, putting a price on a company is an estimate at best. It may be impossible to arrive at a respectable number in the worst conceivable conditions.
Notwithstanding the challenge of putting a price on a company, you also need to make an educated bet as to whether or not it will sell. Some companies are simply more appealing to potential buyers than others. If a company is too tightly linked to its owner, as would be the case if I were to sell “Jeff Rose, Inc.”, the company could not be worth very much. If that’s the case, the company could not be worth anything until I’m involved.
Many business owners, though, simply make educated guesses about how much their companies are worth. A more precise valuation, however, may only be attained by regular professional assessments of the company. And that might only yield an approximation at best.
Likewise challenging is turning a company into cold hard cash. It might not make financial sense to sell if it’s your main source of income. Even if you do manage to sell it, the time it takes to do so is anyone’s guess. To get to the true worth of a company, you must deduct all of its liabilities.
When calculating liquid net worth, most self-employed people should not include their business’s equity.
Home Decor: Furniture and Oddities:
Assigning values based on retail price leads most people to overestimate the worth of their goods. But, the retail value wouldn’t matter at all if you had to convert the cash into another currency. What counts is the maximum price at which they could be sold. That is contingent on discovering a keen purchaser.
In most cases, the value of your personal belongings is just 10% to 20% of their original price. However, there are exceptions, such as certain types of jewelry or pieces of art for which there are already well-established markets.
You should think about how selling your belongings will alter your way of life. It’s possible that selling even the least important of your stuff might be too much for you to bear right now.
The total cash value of $50,000 worth of furniture and decorative items might be no more than $5,000 to $10,000. Since that you probably won’t be able to sell them all, that number will be considerably lower.
Using an Example to Determine Liquid Net Worth:
Let’s look at a simple example to illustrate the dissimilarity between total net worth and liquid net worth.
Your assets are worth $600,000 but your debts amount $300,000. That’s a total of $300,000 in your bank account.
Therefore, we must analyse each item separately if we want to arrive at a figure for liquid net worth:
The Main House:
The current mortgage balance is $200,000, while the worth at fair market is $400,000. You might decrease the price to $380,000 if you want to sell the house soon. A sale at that price would incur additional charges of $38,000, or 10% of the selling price. If you pay off your mortgage and other closing costs, you’ll be left with a net profit of $92,000 from the sale of your home.
Cars:
You currently possess two automobiles, together worth approximately $50,000. (You need to double check the price with Kelley Blue Book or some other reliable vehicle valuation agency.) Your autos are only worth $20,000 after paying off the loans of $30,000, so sell them quickly.
Savings for Old Age:
They are worth a total of $100,000. To completely liquidate the plan, you would need to pay taxes and penalties totaling 30% plus transaction expenses of 1%. This brings the sum down to $69k. In addition, you have a 401(k) loan of $10,000. Your retirement plan has a cash value of $59,000 since you will need to repay that amount upon liquidation.
Household Goods:
You give them a value of $50,000 because that is what they would sell for in stores. Yet, the transaction only nets $10,000. There is no monetary value to your collection of furniture and trinkets because you owe $10,000 on credit cards, most of which were used to make the initial purchases.
Your liquid net worth, taking into account the aforementioned factors, is as follows:
Cost of a Main Home: $92,000 Cars: $20,000 Money Put Apart for Retirement: $59,000 Decorative Items & Home Furnishings: $0.00 To sum up, one’s liquid assets are valued at $171,000.
Reflections on Having a Large Cash Balance:
The gap between total net worth and liquid net worth is dramatic, as demonstrated above.
For this example, let’s assume that our starting net worth is $300,000. But, after taking into account things like marketing, taxes, and transaction fees, we were left with $171,000.
A difference of $129,000 is hardly something to be considered change or a rounding error over.
Having a thorough picture of your financial situation isn’t totally pointless, but it’s also not as precise as you might hope. Knowing your entire net worth as well as your liquid net worth is helpful.
The lesson to be learned is that liquid net worth more closely reflects genuine net worth. In addition, this fact provides compelling evidence in favor of putting away more money into savings and investments than you may currently believe is necessary. If you were to sell all of your assets and pay off all of your debts, your net worth would likely be lower than you now believe. And far less, to boot.