Finance is a multifaceted subject. It cuts across various aspects of our lives and at certain times knocks the wind right out of us. For instance, today I met with one of our wealth management clients and the topic of liquid net worth came up. Yeah, I know liquid net worth doesn’t garner the attention that net worth alone does. However, both calculations have their place in your finances. You really should know why liquid net worth matters and how to determine yours.
In the strategy meeting with the client, I posed the question to him: “What is your liquid net worth?”
He looked dumbfounded. “I don’t even know what that is much less how to calculate it. Is it all the cash I have?” The funny thing is, most people actually believe that liquid net worth is the amount of money in their savings account. Yet, it’s more than just cash-on-hand.
The concept works like this…
if you had to sell everything you own today, how much cash would readily be available?
You have probably never taken the time to figure it all up. Could you answer if your financial advisor asked?
Let’s say you had $10,000 in the bank. Then that cash is worth $10,000. Simple enough on that, right? Now factor in taxable investment accounts. Those are worth whatever market value is as of today.
Now, here’s where it gets murky. Let’s say you have a retirement account with $50,000 sitting in it, and you’re under the age of 59 1/2. If you cash in the account, you’ll be forced to pay income taxes. We’ll use a tax rate of 20-30%. If you have a state income tax as well, factor in another 5-10%. Remember this specific example is for people under age 59 1/2, so cashing that it means you owe a pre-payment penalty too. While that $50k factors into your net worth, if you need to make it liquid (cash you have on hand), you’ll need to cut that amount roughly in half to about $25k. That’s a huge difference!
RELATED READING: Ways to avoid the IRS’s Early Retirement penalty
Another type of investment to consider in calculating your liquid net worth is your direct investments. These are usually non-liquid investments. In other words, these investments are very hard to sell. An example of that would be the interest in your business. If the company is valued (how much someone would pay for it) at $5,000, but you need to sell it quickly, you’ll probably get about $2,000 for it.
Additionally, let’s look at real estate. If you sell a piece of property in most markets—outside the bubble of L.A.—you’ll likely need to discount it by about 20-25% if you want to sell quickly. If your house appraises for $100,000, a smart investor will snatch it up quickly at $75,000. So basically, you’ll need to discount direct investments, illiquid investments, and hard assets to about 50-60% of their actual value.
Other hard assets you may want to factor in: cars, boats, or maybe even a tractor. (Have I mentioned that I REALLY LOVE my tractor?) Say I paid $20,000 for my tractor, but today, it’s book value is $18,000. But in reality, I may actually only be able to get more like $14k for it. So again, that’s another 20% discount, leaving me with only 60-70% of the total purchase value of my tractor.
Basically, when you calculate all these discounts and series of “afters,” you’re left with your total liquid net worth. Most likely, your liquid net worth is only 70% of your actual net worth, or your assets minus liabilities. So you are probably losing 25-30% of something’s value if you need to liquidate your life quickly.
RELATED READING: Questions to ask when hiring a financial advisor
Liquid net worth is pertinent because it allows you to plan for the “what ifs” of life. The importance of this knowledge comes into play if an emergency situation pops up. You’ll want to make sure your liquid assets will cover you. So if your house goes up in flames, if you suffer a major accident, or if you suddenly develop a debilitating illness that requires immediate money, you’ll have an idea of how much you can get, quickly.
While we hope you never need to know yours, at least you’ll have the knowledge to power-through if you do.