Net Worth Explained – How to Get Rich (Part 2)

Nov 15

Written By Eric Gelb

Image sourced by Kushan Pancholi @kushan_1997

Welcome back.

In case you missed Part 1 of this series about building net worth and accumulating wealth, click here.

This week, before we explain Net Worth in greater detail, let’s define a few key terms:

Assets – items you own that have value.

Assets include your house; cash; common stocks; bonds; retirement accounts (e.g., 401(k), 403(b) and IRA); real estate; intellectual property (copyrights, patents); jewelry; precious metals (gold and silver); collectible coins; works of art; cars; boats and other items of value.

Assets could also include ‘stuff’, for example your clothes and the furniture in your house.

I don’t include these items as part of my net worth, because they typically don’t have much monetary value. But they do have value, namely utility value.

These types of assets are often referred to as ‘wasting assets’ because their fair market value declines over time to the point where eventually the asset’s value equals scrap or zero. The money you pay evaporates over time.

Let’s consider for a moment my 2019 Honda CR-V car.

In February 2019, I purchased the car new for $30,855 all in.

Five years later, the Honda dealership emailed me an offer to purchase my car for $18,000. Carvana might offer more. . .

But either way, the decline in value illustrates the point.

Typically, if you purchase a new car, the moment you drive off the dealership’s lot, the automobile losses 30% to 40% of its value. The decline in value represents the dealer’s profit.

A decline in value from $30,855 to $18,000 ($30,855minus $18,000 ) equals $12,855 and represents a decline of 42% ($12,855 divided by $30,855). Ouch.

As I said, a ‘wasting asset’.

How about your living room couch?

You and your friends can sit on your couch every day.

But it’s highly unlikely that you could sell your couch for any decent amount of money. Your couch doesn’t have much monetary value.

But does have value – utility value – happiness from sitting on your couch, watching a movie or the football game; enjoying a glass of wine or two; or as my grandmother used to say, “watching the submarine races”. . .

When I worked at Citibank, every once in a blue moon we would finance furniture – desks and chairs, etc. The Industry called these assets ‘Sticks’. I don’t recall the fair market value but after five or seven years of usage, the items were essentially scrap – worth a nominal amount of money.

Depending on the asset, scrap value typically equals only 3% of original cost. Ouch!

As I recall from my Citibank days, the scrap value of a personal computer (PC) or laptop after three years equals 8% of original cost.

The Finance Industry calls assets including automobiles, furniture and electronics are considered to be ‘wasting assets’.

In other words, the fair market value and utility value of wasting asserts decline over time. And at some point typically, they are worth scrap or zero!

Some assets could have a ‘negative value’. They are worth less than zero. Because the disposal costs exceed the item’s scrap value. In other words, you have to pay someone to take your stuff away.

The point is, think twice Before you purchase a wasting asset and how much money you spend on wasting assets.

Liabilities – amounts you owe to third parties.

Liabilities include taxes, mortgages, home equity line of credit (HEL), credit card debt, student loans, loans for medical treatment, installment loans (for example loans connected with purchasing furniture, electronics, etc.), car loans, business loans and other amounts you owe to third parties.

**Net worth equals Assets minus Liabilities**.

You can think of your net worth as how much money you can spend and/or invest, after you pay off or extinguish all your debts.

Fair Market Value (of an asset) means the money or goods you will receive when you sell or trade an item with another person. This implies that there is a willing buyer and a willing seller who transact at arm’s-length – without pressure or undue influence.

Disposal Costs means money you have to spend to get rid of something. That could be brokerage commissions; costs to dismantle, uninstall and remove an asset; or costs you have to incur to clean up the ground underneath a machine, etc. (remediation).

Net Realizable Value means the cash you expect to receive from selling your asset minus costs associated with the sale, for example disposal costs.

After-Tax means the money you have left after you pay the taxes associated with the sale of the item.

For a moment, let’s consider your net worth and pre-tax versus after-tax assets.

For example your retirement plan assets – 401(k), 403(b), IRA (Individual Retirement Account).

When you contribute money to your retirement plans on a pre-tax basis (in pre-tax dollars), for example through payroll deductions, and take a tax deduction in the year you make the contribution, the money – dividends, interest income and capital gains – is tax-deferred until you withdraw the money.

But when you take a distribution, you have to pay income taxes on the amount of your distribution – the amount of money you withdraw from your retirement plan or retirement account.

Withdrawals are called ‘distributions’.
Since you took a tax deduction equal to your contributions in the year in which you made the contribution, you have to pay income taxes on the distributions (withdrawals) in the year you took the distributions.
In other words, you cannot spend the total, gross value or pre-tax value (fair market value) of your retirement plan assets – 401(k), 403(b) and IRA (Individual Retirement Accounts).
In contrast, with a Roth IRA or Roth 401k account you make contributions in after-tax dollars, so your funds accumulate tax-free and your withdrawals (distributions) are tax-free as well.
BUT be sure to check the current Internal Revenue Code and relevant state and local tax rules and meet with your accountant and financial advisors.

Here’s another example – the sale of say Apple common stock at a gain.

When you sell an investment at a price that is than what you paid, you recognize a capital gain. The gain would be a realized capital gain because you sold the investment.

If you purchased Apple at $50 per share and later sold your Apple common stock for $110 per share, your capital gain would equal $60 per share ($110 minus $50).

You would be liable for capital gains taxes on the gain ($60 per share in this example) which would reduce the amount of money you have available to spend.

Next week, you’ll learn how to calculate your net worth and how to increase your net worth.

P.S. To Boost Your Net Worth, click here.

See you then.

Arthur V.

Disclaimer: OH and Please Remember, we are Not financial advisors, financial planners, attorneys or accountants and are Not providing any specific financial, tax or legal advice here. Be sure to conduct your own due diligence and consult your own professional advisors to get sound professional advice that’s specific to your financial and personal circumstances, risk tolerance, time horizon and investment goals and objectives among other key factors!