I have two things to say regarding net worth. The first is without a doubt, the most important.

1. Your worth as a human being has absolutely nothing to do with your financial net worth. The Joneses, with a financial net worth of 5 million dollars, are in no way better than the family on Main Street just struggling to get by. Financial worth is not the test of life, it’s not a competition, and it’s definitely not the key to joy and happiness.
2. Your financial net worth is the key to financial freedom.

Finding Your Net Worth?

Net worth is traditionally a measure of ones financial health. It is the difference between assets and liabilities.

Put simply, a financial asset is anything that you own that can be converted into your favorite currency: i.e. cash, stocks, bonds, mutual funds, retirement accounts, cars, material goods, and the value of any business or real estate that you own. You can include future pensions and social security benefits if you are close to retirement.

Home ownership is tricky because most people arent in a position to sell their home. Some people claim their home as an asset, and others do not. Or, you can choose to include only the equity (the difference between the market value and the mortgage still owed on the property) as an asset if you would like.

Financial liabilities include anything you have to pay back. Examples include student loans, credit card debt, auto loans, money owed to relatives, etc. If you included the value of your home as an asset, include the money you owe on the mortgage as a liability. All DEBT IS A LIABILITY.

Financial Assets – Financial Liabilities = Net Worth

Why it Doesnt Matter

If youre working towards financial freedom at a young age, the traditional net worth calculation wont help you.

If assets arent going to (or cant) be sold (think your home, car, personal goods), they are temporarily worthless to the individual attempting to cover his expenses with passive income.

Retirement accounts are also particularly tricky, because they arent supposed to be tapped before age 59.5. But you can get around this issue with a SEPP  plan.

Because of these limitations, you might want to exclude certain assets when figuring out if youre ready to exit your current job.

Folks looking to retire before 59.5 should only use a couple of asset classes to determine if they are able to quit their job and continue living. These include:

• All savings accounts, checking accounts, and brokerage accounts that are easily tapped without penalty.
• Retirement accounts, only if SEPPs are possible.
• Any rental real estate minus the debt outstanding.
• Any personal items that you are ready to sell today. Upon sale, you can immediately invest this money and start earning more passive income.

Do not include:

• Retirement accounts that cant be tapped without penalty.
• The home that you live in, unless you are immediately downsizing and will pull out some equity. The house wont pay your bills, or pay you distributions.
• Any motor vehicles or personal items that you intend to keep using. Theyll only depreciate further, or require additional maintenance.

Total up all of your monthly expenses. If you dont know your monthly expense, you should definitely start tracking what you spend. Tracking expenses is a main goal of budgeting, and for good reason! People who refuse to actively track their spending often have horrible financial situations. Tracking expenses forces you to be aware of your spending.

Add up the monthly totals to get an annual expense estimate. Which leads me into

Why It Matters

After youve figured out your annual expenses, multiply that number by 33. If that number is less than your total assets that we calculated above, YOU ROCK. That means you have achieved financial independence and can do whatever you want for the next few decades.

If your total assets are roughly 25 times your annual expenses, youre very close.

You might be wondering why I picked seemingly random numbers like 25 and 33, and then proceeded to make outlandish claims about your finances?

Well, Bill Bengen published a study in the 1990s that tested the historical returns of an equity/fixed income portfolio to find realistic withdrawal rates for retirees. It assumed a fixed portfolio amount, with no new money being saved, and a fixed equity/bond percentage, annual rebalancing, and a 30 year time frame.

It found that in ALL 30 year periods from the early 1900s forward, a retiree could withdraw 4% of the starting portfolio amount, adjusted for inflation each year, and not run out of money in 30 years. Withdraw more than that and you had a chance of running out of money. (Note that the total return averaged greater than 4% per year, but the overage is left untouched to ‘grow’ the portfolio to keep up with inflation.)

Studies have added twists to the original study to test its validity, and the results support the original conclusion. The 4% rule has become the ‘accepted’ rule of thumb for retirement planning and is responsible for the 25x estimated annual expenses that I quoted (1/.04 = 25x).

These studies also conclude that a 3% rate of withdrawal should last in perpetuity (forever) giving the roughly 33x that I referred to earlier (1/.03 = 33x). The 33x number might be more relevant for young retirees because retirement, would last far longer than 30 years.

Some of the studies have shown that it might be possible to obtain higher returns and increase the safe withdrawal rate. For example, if you are able to lower your withdrawal rate in years with poor returns, avoid cost of living increases in some years, slightly tilt your portfolio toward small cap value stocks, etc.

Wrap Up

If you have not yet reached that magical point where you are financially free, youve got some work to do. Thats ok, were in the same boat.

To reach financial freedom, you can either increase your income, or decrease your spending. We recommend both, but if you can only choose one, make it the latter!

Embracing frugality results in financial consequences that will last far beyond your next pay increase.

To show the power of frugality, consider a scenario related to the 4% rule.

Your $100 per month cable bill requires you to accumulate between $30,000 $40,000 in additional assets before reaching financial independence.

$100/month x 12 months x 25 = $30,000 or $100/month x 12 months x 33 = $39,600

For the 4% rule, you easily do the same calculation for any expense by multiplying by 300.

Its a powerful way to change spending habits and reflect on the long term consequences of each financial decision you make.