Calculating The Wealth Gap

In the introduction to this series, we discussed some of the biggest fears that business owners face. As we move forward, I’m going to share several calculations with you that can help put your fears into perspective and even create plans to put them behind you. With that said, today’s post is all about the wealth gap. Not sure what that means? Basically, it’s the difference between where you currently sit, financially, and where you need to be to live the lifestyle that you want to live during your retirement.

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TIME INDEX:

• 00:48 – The Wealth Gap
• 03:12 – Where to Begin: Valuing Your Assets
• 06:28 – Know Where You Are Going
• 09:19 – Taxes
• 11:06 – Calculating the Wealth Gap
• 13:12 – Closing the Wealth Gap
• 16:24 – Your Number One Asset
• 18:25 – Summary

What Is A Wealth Gap?

I live along the Tennessee River in beautiful East Tennessee. Oftentimes, my family and I will take our four-wheelers down to the banks of the river, drop some tubes in the water, and float along enjoying the cool currents of the river. But what if I were standing on one of the river banks and wanted to get to the bank on the other side? The distance between those two banks is the gap. Our wealth gap can be viewed in the same way.

If we are standing on the bank of our financial lives and looking across to the opposite bank that is our retirement, all of that water in between is the distance between our current situation and our retirement goals that we must make a plan for. Without planning, that gap might as well be an insurmountable chasm. As business owners, we spend all of our time and resources working in our businesses and it becomes all too easy to lose focus on anything other than what is directly in front of us.

As a result, we can easily go through a decade or two within our business only to find out that the thing we’ve poured all of our blood, sweat, and tears into for most of our lives isn’t worth nearly as much as we thought it was. Sadly, this is the reality for many business owners. They come to the end of their careers thinking that they will sell their business and live off of the proceeds for the rest of their lives. However, only around 4% of businesses actually sell for what the owner thinks they are worth. With numbers like that, it becomes clear that planning for your retirement, outside of your business is a necessity.

So, How Do You Know How Wide Your Wealth Gap Is?

To know how far you are from where you want to be, first, you must know where you are. Therefore, measuring your wealth gap begins by taking a full assessment of your current income-producing assets, excluding your business and your home. I don’t think of a home as an asset because it doesn’t produce an income. Of course, you could sell your home and downsize, yielding a profit, but you would still need to live somewhere and there will be some cost associated with that whether you rent or own.

We can’t include our businesses in this valuation either because you won’t be drawing an income from your business once you’ve retired from it. Once again, I realize that it can be sold BUT statistically speaking, only around 12-14% of businesses are able to be sold. This means you have to consider the very real possibility that you will never sell your business when measuring your wealth gap. So, the first step in determining what your wealth gap is is to understand where you currently are. For ease of illustration, let’s say that you have a million dollars and it produces an annual income of $40,000 for you ( based on the 4% rule).

Related Content: Can I Really Retire with $100,000 a Year in Income.

Know Where You’re Going!

Equally important to measuring your wealth gap, is knowing what your retirement goals are. When do you want to retire? Will you stay in your current home or will you downsize? Will you be traveling? What sort of lifestyle do you want to have? All of these and more will determine what your specific retirement number will be. You can’t know which way to go if you don’t know where you’re going, which brings me to my next point.

Oftentimes business owners live in and through their businesses. Some of you are saying, “Justin, what does that mean?” Well, I know many business owners who have their cell phones as a business expense. Does that mean that when they sell the business they will no longer have a cell phone? Of course not! It just means that once they are no longer in business, they will have to cover the cost of their cell phones with their personal finances. The same goes for vehicles, WiFi, etc. Once you’ve retired, it’s highly unlikely that you’re going to want to give up the lifestyle that you’ve grown accustomed to.

Because of this, you will need to consider these expenses when calculating how much it will cost to live your current lifestyle well into retirement. Once again, for illustrative purposes, we will say that your current lifestyle (including living in your business) costs around $150,000 per year. If you don’t want to do the math on that, it’s $12,500 each month. Accounting for taxes, you would need a gross income of around $190,000 (this figure may vary depending on your state’s tax requirements) to meet your retirement needs.

The Wealth Gap Formula

As I said earlier, we are assuming that you have $1MM in assets with a 4% distribution rate. Once you’ve reached retirement, you will need roughly $190,000 per year before taxes in order to have an annual income of $150,000 post-tax. So how much do we need to close the wealth gap? Roughly $3.8MM. I know, you’re saying, “Justin, how did you come up with that number?”

You must determine where you are currently, find the pre-tax income that you will need to continue your lifestyle throughout retirement, use the 4% rule to identify the lump sum needed to sustain that income, then subtract your current assets to find your wealth gap. In our illustration, you would need $4.8MM in order to earn the required $190,000 gross annual income from the 4% distribution rate. As you can see in the figure below, while the formula seems complicated when explained in word form, it is actually pretty simple.

Not So Fast… What About Social Security?

Alright, you got me. I was trying to keep things super simple. However, Social Security benefits will factor into your overall retirement plans. For the sake of simplicity, let’s stick with our previous calculations and add to that an extra $40,000 per year in Social Security benefits. In this illustration, Social Security is extremely valuable because the $40,000 in benefits added to the $40,000 from your 4% distribution rate brings your wealth gap to $2.8MM. Wait! What?!

That’s right, that additional $40,000 per year lowered your wealth gap by $1MM. But you’re still facing a $2.8MM wealth gap. Even if you’re 45 years old, you need to save $8,833 per month with a 7% rate of return in order to make up the difference. If that doesn’t worry you, I don’t know what will. But there’s good news. This is not a hopeless situation, my friends! So, how will you bridge that divide? Your business!

Right now, you’re probably thinking, “But Justin, you just told me that only around 12-14% of businesses are able to sell and just 4% of those are sold for what the owner thinks they’re worth.” That’s true. However, I work with business owners every day that are proactively working on their businesses to make them more attractive to prospective buyers. Your business is your number one asset, and even though you want to diversify from your business, you must do all that you can to increase its value and prepare it for a transfer. If you aren’t working every day to make your business more transferable than it was yesterday, you will never close your wealth gap. If you’re not doing that, you will find yourself working in your business well into your 60s, 70s, or even your 80s.

In Summation…

I’m not trying to discourage or frighten you, here. On the contrary, I’m trying to show you how to take action so that you no longer need to fear for your retirement. The wealth gap calculation that I’ve just shared with you is only the first step. By using this calculation, you can quantify your goals. You know exactly where you are and just how far away your retirement goals are on the opposite side of the river.

Over the next few weeks, I’m going to share many calculations just like this one that will help you to remove some of the fear and anxiety that you face. Once you know where you are and where you need to be, you can begin taking direct and focused steps toward achieving your financial goals. So, friends, don’t be fearful. Be motivated. Life is good. Life can be scary. It can be hard, but it’s still so good. With a few simple calculations, finding your wealth gap can at least be financially simple. Hey, let’s go out and make it a great day!

Is your wealth gap a little too large for comfort? Contact us, today! The financial and business experts at Financially Simple can help you to bridge the gap.