Liquid Net Worth: The Basics
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What is net worth?
Net worth is one of the simplest metrics you can use to understand your overall financial health. To calculate your net worth, take your assets and subtract your liabilities.
Net Worth = Assets – Liabilities
Simply put, that means to take the value of what you own (assets) minus the value of what you owe (liabilities).
What are assets?
Assets are things of value that you own – both financial and non-financial. Some of the most common assets include:
- Home value
- Land
- Cash
- Savings accounts
- Checking accounts
- Investments
- Retirement accounts
- Valuable possessions (like art, jewelry, collectibles, etc)
Assets are what you own and therefore they increase your net worth.
What are liabilities?
A liability, in contrast to an asset, is the value of what you owe. Common liabilities include:
- Mortgage
- Loans
- Credit card debt
- Student loan debt
- Auto loans
Liabilities are what you owe and therefore they decrease your net worth.
Why should you care what your net worth is?
Your net worth serves as a benchmark for your overall financial health. It’s a single number, making it easy to track and to determine whether you’re making progress towards your goals. Your net worth is also a helpful indicator to lenders. Along with a few other metrics like your credit score and debt to income ratio, lenders will take a look at your net worth to determine if you are a trustworthy and responsible borrower.
What is liquid net worth?
Liquid net worth is a more specific type of net worth which only accounts for your liquid assets. It sums up how much money you have at your disposal with little to no notice. Liquid net worth is calculated by taking your liquid assets minus your liabilities.
Liquid Net Worth = Liquid assets – Liabilities
What are liquid assets?
Liquid assets include cash and anything that can quickly be converted into cash without losing value.
There are two very important pieces of information in the definition of a liquid asset: time to conversion (i.e. how long it takes to convert to cash) and that it should be convertible without losing value.
What does quickly mean?
A good rule of thumb is that liquid assets can be converted to cash typically within 24 hours. If it takes longer than 24 hours to convert an asset into cash, then that asset is likely a fixed asset.
Common liquid assets
- Cash
- Savings accounts
- Checking accounts
- Stocks and bonds
- Roth IRAs*
Cash, savings, and checking accounts
Why are cash, savings accounts, and checking accounts liquid? Well, cash is already cash, so that one’s easy. Think about the money you have in your checking and savings accounts.
Question 1: Could you convert that asset to cash within 24 hours?
Yes. You can easily convert the money in your checking and savings accounts into cash by heading to your bank or by hitting up the ATM.
Question 2: Will the asset lose any value from being converted into cash?
No. When you withdraw the funds from your checking and savings account, you’ll have the exact same amount of money in cash as you had in the accounts. Of course, if you use an ATM outside of your banking network, you could be charged a transaction fee. But that’s getting a little nitpicky.
So, because cash and money in both your checking and savings accounts can be converted into cash quickly and without losing value, they’re considered liquid assets.
Common fixed assets
- Your home
- Investment properties
- Non-Roth retirement accounts
Your home and investment properties
Why are your primary home and any investment property considered a fixed asset? Let’s work through those two questions again.
Question 1: Could you convert that asset to cash within 24 hours?
Likely not. It’s not impossible, but it is very unlikely that you could put your house or another investment property up for sale and have cash in hand within 24 hours.
Question 2: Will the asset lose any value from being converted into cash?
Real estate falls into the appreciating asset category, meaning real estate typically increases in value over time. However, what you’re able to sell your property for will be contingent on what’s going on in the market.
If it’s a buyers market, you may very well have to sell your property below value, especially if you’re attempting to sell it quickly. However, if it’s a seller’s market, you may be able to sell your property at or above value. In either market scenario though, there are fees and taxes associated with selling real estate that may eat into the value of the property.
So, by the fact that real estate cannot typically be converted into cash within 24 hours, and incurs at least some transaction fees and taxes through the sale, real estate is considered to be a fixed asset.
*Why the asterisks?
You’ll notice that stocks, bonds, and Roth IRAs are listed as liquid assets, but non-Roth retirement accounts are listed as fixed assets. Why is that?
Stocks and bonds
Stocks and bonds fall into a bit of a grey area but are typically more liquid than fixed. For this asset classification, we are strictly speaking about stocks and bonds that you may own in a separate brokerage account that aren’t a part of a retirement account (such as a 401(k), IRA, or TSP). This type of brokerage account is a non-tax-advantaged account that allows you to buy, sell, and trade securities. It operates similarly to an IRA, but without the tax advantages.
Let’s refer back to our two liquidity questions:
Question 1: Could you convert that asset to cash within 24 hours?
Yes. Stocks and bonds can be sold within 24 hours. The only exception is if you attempt to sell during the weekends or on a holiday when the market is closed.
Question 2: Will the asset lose any value from being converted into cash?
Possibly. Similar to real estate, the selling price of stocks and bonds are susceptible to market fluctuation. It is likely that you could sell at a loss or for a profit, depending on what’s going on in the market. Attempting to sell on short notice (within 24 hours) could potentially limit your ability to sell at a profit because you can’t use time to your advantage. Additionally, if you sold your stocks or bonds for a profit, you may be on the hook to pay either long or short term capital gains tax.
So, since stocks and bonds you own in a non-retirement brokerage account can be sold quickly, but are susceptible to market fluctuation (which may cause you to sell at a loss on short notice), they’re classified as mostly liquid.
*Roth IRAs
It’s important to note that there are a number of different tax-advantaged Roth retirement accounts, such as Roth TSPs, Roth IRAs, and Roth 401(k)s, all of which have similar benefits. However, Roth IRAs are the most common Roth retirement account.
Roth IRAs exist in a bit of a grey area when it comes to evaluating their liquidity. One of the many advantages Roth IRAs have over other types of non-Roth retirement accounts is the flexibility of withdrawals. While you can begin taking your money out of a Roth IRA at age 59 ½ for any reason without penalty, there are some helpful exceptions you can utilize to make a withdrawal much earlier if needed.
Once a Roth IRA account is at least 5 years old, you can withdraw contributions (but not earnings) without any taxes or penalties.
There is also a short list of exceptions wherein you can withdraw funds (both contributions and earnings) earlier than age 59 ½ without penalty. If your account is not yet 5 years old, you’ll pay taxes but no penalties. And if your account is 5 years or older, you won’t pay any taxes or penalties for the following qualified early distribution reasons:
- Qualified first time home purchase
- Qualified educational expenses
- You become disabled
- Qualified medical expenses
- Paying for health insurance while unemployed
So, Roth IRAs are mostly liquid assets because they can be converted quickly to cash. They can be converted in many instances without taxes and penalties that would cause a loss in value. However, your Roth IRA is built up of stocks and bonds, so you are still susceptible to market fluctuation which may impact your ability to sell for a profit. Thus, Roth IRAs are mostly liquid.
Why are retirement accounts fixed assets?
So, if Roth IRAs (and other Roth retirement accounts) are mostly liquid, why aren’t non-Roth retirement accounts liquid? Retirement accounts such as Traditional IRAs, TSPs, and 401(k)s do not offer as much withdrawal flexibility. Taking disbursements before reaching the designated age (typically 59 ½) will come with heavy penalties. Therefore, while the assets can be quickly converted to cash (just like any stock or bond in a brokerage account or Roth IRA) it will lose value in the conversion via a 10% early withdrawal penalty.
An alternative to fixed vs. liquid assets: the discount method
As an alternative to categorizing fixed versus liquid assets, some people utilize what’s called the discount method.
Essentially, it allows you to apply a discount percentage to fixed assets so that you can qualify them as liquid assets. For example, instead of qualifying a 401(k) as a fixed asset prior to the age of 59 ½, you could simply discount the total by 10% (accounting for the tax penalty you’ll incur) and count the remaining 90% as liquid.
If your 401(k) fund totaled $50,000, the discount method would assess that $45,000 of the fund is liquid and that $5,000 was lost in value through the tax penalty assessed in converting it to cash.
However, this method has two significant drawbacks.
- Calculating a discount might work some of the time. When you know the exact tax penalty percentage, it’s easy to calculate. However, what kind of discount percentage would you apply to real estate? Sure, you may know some of the exact taxes and fees, but no one can predict what the market will do in the future. Will it be a buyer’s or seller’s market at the time you decide to sell? Applying an arbitrary discount percentage to many fixed assets isn’t likely to be very accurate or helpful.
- You should never evaluate your assets with the intention of them losing value. It’s better to evaluate your liquidity needs and adjust your investments and wealth-building strategy accordingly. In doing so, you’ll be able to retain and grow the value of your assets without taking on unnecessary penalties and taxes.
Why should you know your liquid net worth?
Your net worth paints a picture of your overall financial health. Your liquid net worth, on the other hand,sums up the amount of money you have at your disposal. Whether you may need money quickly for an emergency, loss of a job, or unforeseen opportunity, your liquid net worth is what you’ll have immediately available to you.
How to track liquid net worth?
Recall, your liquid net worth is simply your liquid assets minus your liabilities. There are a few different ways you can calculate and track your liquid net worth: by hand, with an excel sheet, or through a net worth app.
The easiest way by far is to utilize a net worth app where all of your financial accounts are connected and automatically updated for you. While most apps will show your net worth, rather than your specific liquid net worth, you’ll have all the updated information at your fingertips to run the last few calculations. Simply subtract your fixed assets from your total net worth. At the Ambitious Dollar’s, our favorite net worth app is Personal Capital.
The bottom line
Both net worth and liquid net worth are important numbers to know when assessing your financial health and tracking progress towards your goals. However, they aren’t something to fixate on. Think of them as tools to help you understand how you can best meet your needs and grow your wealth. Utilize the information they show you to develop a plan – whether that’s to pay down debt, increase your investments, diversify your portfolio, or any combination thereof.
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