At the beginning of the year we notice an uptick in the inquiries coming into our financial planning practice. Our industry along with the health clubs is seasonally popular perhaps because we’re all recovering from a season of overeating and overspending. You won’t find any financial fad diets in this column, but we should to take advantage of this convenient time to evaluate your financial health.
First, we need to determine your net worth as of the end of the year. Simply put, your net worth is tallied by adding up the value of your assets and subtracting your debts. When computing assets, we consider financial accounts like a 401(k) and also real estate such as your personal residence and rentals. For this exercise when calculating assets, we should ignore household goods and furniture, with the exception of vehicles. Your debts include your credit card balances (even if you pay them off every month), mortgage, home equity line of credit, student loans, car loans and other personal loans.
As an example, let’s consider the mythical McElmore family who lives in Boulder County. Conservatively their house is worth $630,000 with a $350,000 mortgage against it and a $40,000 home equity line they used to finish their basement. Maria has $130,000 in her 401(k) and a total of $60,000 in her IRA and Roth IRA. Matt has a $170,000 in his 403(b) plan through work, and a $30,000 Roth IRA. They have $14,000 in savings and checking, and own two vehicles worth a total of $25,000 per appraisals at Edmunds.com. Matt has $30,000 in student loan debt, and although they pay their credit cards off every month, their combined balances have spiked up to $5,000 due to holiday spending. They have a $6,000 loan on one of their cars.
Once we add up their assets, the total is $1,059,000, while their debts are $431,000. That gives the McElmores a net worth of $628,000. Their investments are worth $404,000, which excludes the values of the house and the cars.
Next we need to figure out how much you spent in 2017. Some of you may be Mint.com or Quicken wizards, but many more of you will have just a vague idea of your spending last year. Don’t worry we have other ways of getting there. The quickest approach is what I call a top-down analysis. Rather than worrying about what you spent money on last year, we use our account statements to come up with high level numbers.
Let’s have the McElmores guide us on how to get an annual spending number. We look up their checking balance at the end of 2016 and see they had $9,000 in savings. Their credit cards at the end of 2016 totaled $8,000, because they went on a holiday trip that year. Matt is paid $70,000 a year, with take home pay of $2,200 every two weeks in 2017, while Maria is paid $80,000 annually, and after deductions receives $2,500 twice a month. They made a one-time $3,000 payment in 2017 toward Matt’s student loan debt, in additional to the regular monthly payments.
We now know how much the McElmores spent in 2017. We know from their paychecks Matt took home $57,200, while Maria netted $60,000 last year. They made a one-time debt paydown of $3,000 and that their credit card balance was $3,000 lower at the end of 2017 than 2016. If we combine the take home pay ($117,200) and then subtract the net debt paydown of $6,000, we get spending of $111,200 annually or $9,267 a month.
With the McElmores’ net worth of $628,000, investments of $404,000, household income of $150,000, and annual spending of $117,200, we’re prepared for a high level view of their finances. The first question is do the McElmores have investments that exceed seven times their annual spending? This is the threshold for Financial Independence. With investments of $404,000, they have 3.4 times annual spending so they fall short. Then our focus is on their net worth ($628,000) compared to their incomes ($150,000). With a ratio of 4.2, this places the McElmores in the Rapid Accumulation stage, on track for a couple in their 40s to early 50s. Rapid Accumulation is defined as the stage when your investments tend to appreciate more than you are able to save out of your income in a given year. This is when people tend to accelerate their financial progress.
If your net worth is below your annual income, then you’re getting started in the Building the Foundation stage (typically in your 20s). If your net worth is one to three times your income, you’re in the Early Accumulation stage, a target in your 30s. The Rapid Accumulation stage is having a net worth of three to seven times income, like the McElmores, with an aim to get here in your 40s to early 50s.
Once you move into the Financial Independence stage, defined as investments (not net worth) being a multiple of seven to ten times annual spending (not salary), you are on your way to making work optional. Conservation (investments 10 to 15 times annual spending) and Distribution (investments more than 15 times annual spending) are the final stages. If you’ve reached a traditional retirement age, you’re likely ready to retire once you reach the Conservation stage.
This Financial Lifecyle model, created by Bert Whitehead, a member of the Alliance of Comprehensive Planners is a quick, useful way to evaluate your financial health in a way that recognizes the virtue in accumulating wealth in the context of spending. It doesn’t work for everyone. But its vital quality is its emphasis on the relationship between wealth and spending when determining whether you’re on track to make work optional. In a future column, we’ll cover the other Lifecycle Stages and their implications for your finances. Until then, write down your net worth, investments assets, income, and annual spending so you can see your progress at the end of the year.