It's common to focus on income as the deciding factor for wealth, but income doesn't tell the whole story. Consider the perennial news articles about sports stars and actors who've declared bankruptcy despite their multimillion-dollar salaries; they have super-high incomes, yet can't even pay their bills. That's why net worth is a much more realistic and accurate measure of your wealth.
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What is net worth?
Net worth is the value of everything you own, minus everything you owe. It's entirely possible for someone with a very low income to have a substantial net worth, if they're careful about debt and save money regularly. It's equally possible for someone with a very high income -- like those bankrupt sports stars -- to spend every penny they make and then some, resulting in a negative net worth.
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Net worth determines wealth
Wealth has several possible definitions; open up your dictionary and you'll probably see at least five or six. The one that probably comes closest to the way we think of wealth in the context of being wealthy is this one from Dictionary.com: "an abundance or profusion of anything; plentiful amount." Being wealthy boils down to having more money than you need. And that's why net worth is a better determiner of wealth than income: your income doesn't say anything about how much money you have available right now, it just says how much money will be coming in on a periodic basis. Net worth is how much you have in cash and other assets to spend today, and if you have more money available to spend today than you need, you are by definition wealthy.
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How to calculate net worth
Figuring out your net worth is not complicated, although it may take some time. First, add up all the money and money-equivalent assets you have: checking accounts, savings accounts, investment accounts, retirement accounts, the money in your wallet, and the spare change in the cracks between your couch cushions. Next, add up the value of your physical possessions. Your house would be on this list of course (assuming you own it) but so would your car, furniture, artwork, jewelry, TVs, and so on. To get an absolutely accurate net worth number you would include every single thing you own down to that sock in your drawer that's missing its partner, but you don't need to go into that much detail to get a reasonably close total; you can limit your tally to your more valuable possessions. And remember, the things you own are not valued at what you paid for them but what you could sell them for today. Finally, add up the total amount of your debts and subtract this number from the value of your cash and everything you own. The easiest way to total up your debts is to pull a copy of your credit report, subtract any payments you've made that aren't yet reflected on the report, and use that number.
What is a good net worth?
The book The Millionaire Next Door suggests the following formula to calculate what your net worth should be:
(Age x Annual Pre-tax Income) / 10 = Target Net Worth
Using this formula, a 40-year-old man with an annual pre-tax income of $60,000 per year would calculate his target net worth as 40 x 60,00010, or $240,000. If this number looks really, really high to you, you're not alone: the average American falls far short of the target net worth indicated in this formula. According to US census data, 40-year-olds actually have a median net worth of about $35,000, not $240,000.
Setting your own target net worth
The first step in growing your net worth is setting a goal for yourself. If you set a goal, you can also create a specific plan that will take you to that goal; if you don't have a goal, how can you decide what to do next? For example, let's say that you are the 40-year-old in the previous example and your net worth is $40,000. You're doing a bit better than the average, but you really want to get your net worth up to where the formula from the book says it should be, which is $240,000. You need to increase your net worth by $200,000 to get there. Now that you have a specific number, you can set a timeframe and mini-goals to get you to your ultimate goal no later than your deadline.
How to increase your net worth
To increase your net worth, you need to increase your assets, decrease your debt, or (preferably) both. The fastest way to increase your assets is to pump up your retirement contributions. Because the money you put in a 401(k) or IRA can grow tax-free, you can get a slightly better return than you would on the exact same investments in a standard brokerage account. Plus, your contributions to traditional retirement accounts are tax-deductible, so you can turn around and use the money you save on taxes to increase your net worth further. Decreasing your debt is a worthwhile goal for a lot of reasons, especially if you have a lot of expensive credit card debt or other high interest debt. In fact, getting rid of high interest debt is a higher priority than bumping your retirement contributions, because the interest you pay on your debt will more than cancel out the returns you get on your retirement savings.
A plan for increasing net worth
Let's say you want to increase your net worth by $200,000 and you've decided to set a timeframe of 15 years. For the purposes of this example, you have $5,000 of credit card debt at 18% interest but other than that, your only debt is a low-interest mortgage. The first step in the plan would be to get rid of the credit card debt, and you decide that your goal is to pay it off within one year. You fire up a debt calculator and discover that if you pay an extra $400 per month on your credit card over and above the minimum payment, you'll have it paid off in 11 months. You scrape together the extra $400 by cutting back on expenses, and get it paid off on schedule (don't forget to reward yourself for reaching your first goal!). Now you've got an extra $400 every month cleared from your budget, so why not start putting that $400 toward your retirement contributions? Assuming that you have $20,000 in retirement savings now and you've been contributing just $100 per month, increasing your contributions to $500 per month means that with an average annual return of 7%, your retirement savings balance will grow to $196,345 in 14 years. Since you'll also be paying down your mortgage over those 14 years, that should be more than enough to get you to your target net worth even if your house doesn't increase in value at all. What's more, those calculations assume that your contributions won't increase over that 14-year time period. If you punch these numbers into a savings calculator and add just a 3% annual increase in contributions, you'll see that you'd hit a retirement savings of $199,277 after 13 years, not 14. Suddenly that target net worth doesn't sound so impossible, does it?
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