Your Net Worth is Gross

Which weighs more, a pound of feathers or a pound of bricks?

Trick question of course but consider this:  two couples have the same net worth, $2 million.  One couple has $2 million in Roth IRAs and the other has $2 million in taxable IRAs.

Which couple has the higher net worth?  Obviously, the first couple, because they have no tax liability on this money. 

Based on this simple example, I’d like to introduce the concept of Gross Worth to differentiate it from Net Worth.

We are told that Net Worth is all of your assets minus all of your liabilities.  This is really Gross Worth.  Gross Worth does not account for the transactional cost of accessing your money. 

Net Worth is Gross Worth less transaction and tax costs of converting assets to spendable cash. 

Why this matters:  in very general terms one achieves Financial Independence (FI) when one’s Investment Net Worth is 25x one’s net annual expenses (subtract income sources such as rental income, social security, pensions from annual expenses, investments must cover the rest).   However, when considering the transaction costs and tax consequences of converting various investments/assets into cash, it turns out that what we have been counting as Net Worth has been Gross Worth and we must take the difference into account.

Before proceeding further let me stipulate that I am neither a tax expert nor an estate expert.  The information below is my understanding of the consequences of converting various assets to spendable cash.  It is not advice.  If you have better information, please post it in the comments. 

Let’s work our way through various assets and account types to see how this works. One term that will come up is Basis – this is your cost/value of an asset for tax purposes. 

Real Estate

Personal Residence:  Financial planners typically exclude one’s personal residence from net worth calculations, as they should when preparing an income statement/budget. After all, one cannot spend one’s house to pay the utility bill.  That said, a house is still part of one’s worth, but we should separate gross worth from net worth.  Typically, the calculation is the current market value of the house less the mortgage. However, if one is selling the house, the transaction costs reduce its value.  Where I live, this can easily be 9-10% of the selling price.

One might also monetize this differential by refinancing, taking out a second mortgage or a HELOC. Finally, as one ages it becomes possible and perhaps valuable to do a reverse mortgage.  This can be thought of as one’s final emergency fund if one is able to stay in this home. These refi options come with transaction costs and lenders will not normally refinance up to 100% of a home’s value.

Finally there is the tax consideration.  Under current tax law there is a $250,000 exemption for single filers and a $500,000 exemption for married filers on the profit one makes from selling one’s personal residence. One must reside in the home for at least 2 of the last 5 years.  So, if one has lived in a house for a very long time and the gain from the sale of the home is higher than these amounts, the difference is subject to capital gains tax.  If one does not keep the house for 2 years then there is no exemption. In either case, the gross worth of the equity in one’s house may not be the same as one’s net worth.

The final consideration is inheritance. If the house passes to a child, the child gets a step-up in basis, meaning the starting point for future tax calculations becomes the value of the house on the date of death. 

In my own net worth calculation, I value my house at less than market value for these reasons.

Rental Real Estate:  The same transaction cost caveat as described above applies to rental real estate as well. One way investors can pull cash from their properties without selling them is to refinance occasionally, assuming of course the property has appreciated.  As noted above, there are transaction costs for refinancing. The advantage to this strategy is that one delays paying taxes, as would be the case when selling the property. Net worth calculations should take into account these transaction costs if this is the strategy.

Speaking of tax considerations, taxpayers are required to depreciate rental real estate. This shields some current year profit from current year income taxes but not necessarily forever.  When selling rental real estate, the accumulated depreciation is recaptured – this means it is taxed at ordinary rates.  The remaining gain on the sale is taxed at capital gains tax rates.  Reminding the reader that I am not giving advice, I always set aside 1/3 of the amount I received from selling rental property to cover the recaptured and capital gains taxes and at the tax rates in effect at the time this proved to be enough.  Effectively this meant that my net worth for these properties was 2/3 of Gross Worth.

Heirs also benefit from step-up in basis for this asset.

Jewelry and Collectibles

What are the chances that you have kept track of the purchase price of every valuable piece of jewelry, or every collectible coin, stamp, or piece of art?  Mine are 0.  At least with coins and many stamps there is a face value (until forever stamps came along anyway). Determining gross or net worth of any of these assets seems problematical, and financial planners typically do not include them.  If we are talking about real value here, an appraisal will be needed and this will be the transaction cost.  If one is selling to a dealer, since they are in business to make a profit, they will offer something less than current market value and this should also be considered (ever watch Pawn Stars?).  Heirs will benefit from step-up in basis but the appraisal would be required to determine what that new basis is.  Depending on the value of these assets, they should be insured, which is an annual cost to consider. 

Financial Instruments:  Stocks/Bonds/Mutual Funds/ETFs

Financial assets (stocks/bonds/Mutual Funds/ETFs) are cheap to buy/sell (transaction costs) and easy to convert to cash.  This was not always the case.  Forty some years ago, when I was in my 20s, these assets had the following characteristics:

  • Stocks had to be purchased in lots of 100 shares or an odd lot fee was charged.  One could only purchase shares in whole units and a commission was charged for each transaction.
  • Bonds had to be purchased in groups of at least 3 (my best recollection) and commissions were charged
  • Mutual Funds had front-end loads (purchase price commission) as high as 5.75%.  There were annual fees on the accounts and the annual costs paid by the fundholders to the fund managers could be 2-3% or more. 
  • ETFs did not exist.  (there are only slight differences between ETFs and MFs for those who trade infrequently they are insignificant). 

This has changed greatly in the past 20 years. 

  • Stocks can be purchased in any number of shares, even fractional shares with no penalty.  The purchase is commission free when purchased online. 
  • Bonds can be purchased individually.  I don’t do this so I am not sure if there is still a commission or trading fee.
  • Front-end loaded mutual funds still exist, but there are so many more no-load options and the front-end loaded mutual funds do not perform any better so there is no need to buy them.  I no longer pay annual fees.  This may be because of the value of my account though.  The annual costs for many funds, especially index funds for non-specialty funds are typically less than 0.5% and index funds are as low as 0.03% or less.
  • There are equivalent ETFs for existing mutual funds and the industry seems to be heading in this direction.  To the investor the only differences I am aware of are that the valuation is calculated in real time (MFs are valued at the end of the trading day), and transactions occur immediately.  With MFs, the trade occurs at the end of the trading day when the fund is valued for that day. 

For these financial instruments the transaction cost is now zero or close to zero, so this does not impact the difference between Gross and Net Worth. 

The impact to Gross vs Net worth is a function of what account type financial instruments are held in.  Account types include after-tax, retirement pre-tax, retirement Roth, HSAs, and inherited variations.

After-tax accounts – these are accounts set up at your favorite brokerage (eg Vanguard, Fidelity, Schwab) with after tax money.  One may fund these accounts by setting up a transfer relationship between a checking account and the brokerage account.  One transfers money from the checking account to the brokerage account and then chooses one or more of the financial instruments described above.  One can schedule transfers and automatic purchases as well. 

The tax consequences of these accounts can depend on the holding period and the exact instrument being purchased.  Investments held for less than one year are taxed as ordinary income.  Investments that are held for more than one year are taxed at lower capital gains rates.  Fully qualified dividends (FQD) are also taxed at capital gains rates.  Mutual Funds/ETFs may report dividends (FQD or ordinary dividends) and capital gains monthly, quarterly, or annually (or any combination).  One can somewhat control how much one earns in dividends and capital gains with the purchase/sale of individual stocks.  One has no control over this with MF/ETFs.  Some MF/ETFs will attempt to keep these to a minimum, others may not.  One can donate appreciated assets from these accounts to a charity (without selling them first) to avoid paying taxes on them, yet still get credit for the appreciated amount (if itemizing deductions).  Heirs realize a step-up in basis for these assets.

The Gross Worth/Net Worth difference then is determined by how one disposes of the assets (sells them, donates them, bequeaths them).

Retirement Pre-Tax – these include traditional IRAs, 401Ks, 403Bs, TSPs, etc.  Traditional IRAs are set up similarly to after-tax accounts (open account with your brokerage firm, fund from your checking account).  They are designated as IRA accounts and there are annual contribution limits and income limits.  The other traditional accounts are set up through one’s employer (self-employed individuals have additional options based on how their self-employment is set up). 

The money invested in these accounts is subtracted from taxable income in the year contributed, saving the taxpayer on federal and state income taxes.  Taxes are paid on withdrawals which are taxed as ordinary income no matter the financial instrument.  As this income has never been taxed, the government requires the taxpayer to begin distributions in their early to mid-70s (exact date depends on date of birth).  These are called Required Minimum Distributions, RMDs.  RMDs are based on life expectancy tables.  They start close to 4% and increase with age.  A portion of the RMD can be donated to charity, avoiding the taxes on them (but they are not deductible on one’s taxes). 

With some specific exceptions outside the scope of this article, one cannot withdraw from these accounts until at least 59.5 without paying a 10% penalty. 

The rules on inheritance depend in part on what year the owner dies.  There is no immediate tax consequence for spouses, but for all others they will pay the taxes on this income.  I am not qualified to address all the complexities.  Depending on the details many may be required to take withdrawals (and pay the income taxes) over a 10-year period.  Others will be required to take withdrawals based on their life expectancy or the life expectancy of their bequeather. 

The difference between Gross Worth and Net Worth for pre-tax accounts depends on the taxes (and possibly penalties) one may pay on the distributions.   This difference can be significant.  Planning may be useful to optimize when to take the distributions based on one’s specific future income expectations.  One will only know if the pre-tax retirement account was a better option than other retirement accounts much later in life.

Roth Accounts

Roth accounts are funded with after tax dollars and grow tax free forever.  So, the Gross Worth value and Net Worth value of these accounts are identical.  They are tax free to heirs as well. 

HSA Accounts

HSA (Health Savings) accounts can be triple or quadruple tax free.  To open an HSA account, one must choose a qualifying high deductible health plan.  The insurance premiums for these plans are typically much cheaper than for standard plans and when subsidized by one’s employer, can be very inexpensive.  The drawback of course is the high deductible, i.e. the annual maximum out of pocket expenses.  For ACA plans I have seen the deductible in the $13000 range, but for corporate sponsored plans it can be as low as $6000.  These numbers are for family coverage. These plans can work best for families that generally have low annual medical expenses and for families that are likely to max out.

The tax savings for choosing these plans include:

  • Contributions are made pre-tax and can be invested in a number of ETFs depending on the plan.
  • Investment growth is tax free.
  • Withdrawals are tax free if there are corresponding covered medical expenses that can go back to original time of enrollment in the plan. 
  • The 4th benefit depends on the amount of FICA wages earned per year.  The current FICA maximum is about $168,000.  If one earns less than this per year, and if the HSA contributions are made through payroll deductions, the amount contributed is not subject to the FICA tax. 

In addition, employers may make contributions to the HSA.  There is an annual cap on contributions, regardless of who contributes. 

The strategy works well for those who can pay their medical bills out of pocket while letting the account grow.  It does require one to keep records of the medical bills accrued during the life of the plan, to be able to use this money tax free later.  If the account outgrows one’s total accumulated medical expenses, the remaining value in the account can be used as a taxable IRA at age 65 (no RMDs apply though).  If an account is bequeathed to a child or other non-spouse beneficiary, it is taxable income to the heir in the year of the bequest.

If one has enough medical expenses to withdraw from this account later in life, then the Gross Worth of this account is equal to the Net Worth.  If the account effectively becomes a taxable IRA or is inherited by a non-spouse, the normal differences in GW vs NW would apply.  

Summary

The transaction costs and tax consequences of liquidating an asset can reduce its cash value.  It is therefore helpful to think of the market value of an asset as part of one’s Gross Worth and the liquid value of that same asset as part of one’s Net Worth.  The value to a beneficiary may be maintained by step-up in basis but may be reduced by tax consequences as well.  A pound of feathers may not weigh the same as a pound of bricks.

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