Deferred Tax Liabilities in Net Worth Calculation

[Helios]

When calculating your net worth, how do you account for deferred tax liabilities?

For example, starting with $0, say you invest $40k per year for 10 years and get a 10% return each year; you will end up with about $670k at the end of 10 years, of which $400k you contributed and $270k is a gain.  But this $670k asset now has a deferred tax liability attached to it.  If you did this in a taxable account, the $270k gain would be subject to capital gains tax upon liquidation; if you did this in a 401(k), the entire $670k would be subject to ordinary income tax rates upon liquidation.  How do you account for this deferred tax liability as part of your net worth?

(1) Do you ignore it through hand-waving, because your taxes will be "low" when you FIRE due to low consumption?
(2) Do you use a low blended expected tax rate for all of your deferred tax liabilities (maybe 12% federal and 5% state so 17% total)?
(3) Do you have a more detailed calculation that splits out ordinary income from capital gains deferred tax liabilities?
(4) Do you ignore deferred tax liabilities which you are not likely to pay (maybe you have $3 million and live on $30k per year)?
(5) Do you use a high marginal tax rate, knowing that you are being overly conservative?

What is the best way to think about discounting your net worth for deferred tax liabilities?

[seattlecyclone]

Mostly (1) for me. When I retire I'll have some combination of taxable assets, pre-tax 401(k)/IRA assets, and Roth assets. Assuming tax laws stay about the same as they are now, I'll be able to do Roth conversions up to the standard deduction/personal exemption ($20.6k for a married couple this year) and have dividend/capital gains income up to the top of the 15% bracket (another $74.9k of income), all without owing any tax. We can have even more tax free income if we have kids living with us (none yet though). Our retirement spending will come first from taxable accounts and then from Roth basis when the taxable accounts are exhausted and the Roth pipeline is well primed.

[arebelspy]

Realize expenses as they occur.  Plan out cash flow projections for FIRE re: 4% WR.

[Cheddar Stacker]

Good question.

As seattlecyclone points out with proper planning you can keep it very, very low. But things have to go according to plan.

As arebelspy points out you can just add it to your monthly/annual expense needs during retirement, then factor that into your FIRE number.

When I initially made a NW spreadsheet I kept a column for "tax liability" and showed a "Net of tax" column, but that was before I learned a shitload more about how to get around most of those taxes by reading here and elsewhere in the ER community.

I ignore it for now for seattlecyclone's reasons, but I've started to consider going with your option #3 as a separate column in my NW spreadsheet like I used to. Maybe keep a column called "FU Money" where I calculate exactly how much CASH I could liquidate immediately. My "Getaway Money". That way if everything falls apart all at once, I know I could walk away with $xxx,xxx in cash today. I'm not sure it's worth it, but it wouldn't take too much effort.

[Mississippi Mudstache]

(1) Do you ignore it through hand-waving, because your taxes will be "low" when you FIRE due to low consumption?

I wouldn't call it "hand-waving", but yes, I ignore income taxes. I'm not liable for any now, and I don't expect to be liable for any in the future. I guess you could also say that I plan for my tax liability to be exactly the same in retirement as it is during my working years.

[slugline]

I could see how it might be useful to do this exercise to estimate your projected net worth in the future, but including it in calculating your present-day net worth feels incorrect to me. Wouldn't it be like subtracting all the remaining interest from a mortgage amortization table right now, or including a present asset value on the future benefit payout from Social Security?

[Cheddar Stacker]

@slugline, I intend to pay very little tax after I FIRE. However, if suddenly my job collapsed, and then I had a stroke and had no disability, and then etc.....I think it might be valuable to know exactly how much cash I actually have net of all commissions, taxes, penalties, etc if I had to cash it all out at once. That's kind of what I thought I might use something like this for. Unlikely scenario, but easy to figure out and it couldn't hurt to know.

So I see more value in doing this on today's NW than I do my post FIRE NW, since I will be able to manipulate the way I liquidate then.

[Helios]

Thanks everyone who responded!

I guess I was thinking about this topic because during the summer of 2014 I achieved a milestone amount of financial assets which, ignoring deferred tax liabilities, would make me FI at a barebones level (though my current spending is higher due to discretionary items I value).

Realize expenses as they occur.  Plan out cash flow projections for FIRE re: 4% WR.

If we are to realize expenses as they occur, when do they occur?  I think it's implied in your quote that the expense occurs when you sell (is that a fair reading of your quote?), but I'm not sure I'm sold on that.  The alternative view is that the expense occurs when the securities appreciate (creating an unrealized gain), and I think this is the view that GAAP accounting for businesses takes, that companies are required to record deferred tax liabilities against deferred / future / unrealized income.  I am personally pretty firm on the accounting theory that expenses can occur in a different period than a cash outlay.

Now, personal finance accounting is not business accounting, but I'm not sure why we should think about this particular topic differently.  On  the other hand, I am clearly in the minority of opinion, judging not just from responses to this thread, but from the searching I did for similar threads (before I started this one); none existed.

I could see how it might be useful to do this exercise to estimate your projected net worth in the future, but including it in calculating your present-day net worth feels incorrect to me. Wouldn't it be like subtracting all the remaining interest from a mortgage amortization table right now, or including a present asset value on the future benefit payout from Social Security?

I am not completely sure I understand this question: "Wouldn't it be like subtracting all the remaining interest from a mortgage amortization table right now[?]" - I think future interest expense should be excluded from your balance sheet / net worth calculation.  Your balance sheet should include the principal balance of your mortgage only - whatever you could pay it off today for.  If you don't pay it off today, then the projected interest expense from the table becomes actual interest expense, but not before.

As to the second point regarding the present value of expected Social Security benefits, I would just advise people to be conservative.  I'm not one to make predictions about future acts of Congress regarding individual programs, but in general, the "haves" get taxed to provide for the "have nots."  If you are reading a pedantic discussion on an early-retirement-focused personal finance message board regarding whether to include certain minutiae in your personal net worth calculation, then you are most likely a "have."

@slugline, I intend to pay very little tax after I FIRE. However, if suddenly my job collapsed, and then I had a stroke and had no disability, and then etc.....I think it might be valuable to know exactly how much cash I actually have net of all commissions, taxes, penalties, etc if I had to cash it all out at once. That's kind of what I thought I might use something like this for. Unlikely scenario, but easy to figure out and it couldn't hurt to know.

So I see more value in doing this on today's NW than I do my post FIRE NW, since I will be able to manipulate the way I liquidate then.

I think this is helpful.  Thanks.

[slugline]

I could see how it might be useful to do this exercise to estimate your projected net worth in the future, but including it in calculating your present-day net worth feels incorrect to me. Wouldn't it be like subtracting all the remaining interest from a mortgage amortization table right now, or including a present asset value on the future benefit payout from Social Security?

I am not completely sure I understand this question: "Wouldn't it be like subtracting all the remaining interest from a mortgage amortization table right now[?]" - I think future interest expense should be excluded from your balance sheet / net worth calculation.  Your balance sheet should include the principal balance of your mortgage only - whatever you could pay it off today for.  If you don't pay it off today, then the projected interest expense from the table becomes actual interest expense, but not before.

BINGO!

Likewise, deferred future tax liabilities are just as (un)certain. Sure you can calculate a number based on today's tax brackets, but Congress has changed those before, and they can change them again.

Likewise, I would hope my investments grow at a 7-10% rate or more, but would it really be useful to count that future growth in my net worth right now???

[Helios]

I could see how it might be useful to do this exercise to estimate your projected net worth in the future, but including it in calculating your present-day net worth feels incorrect to me. Wouldn't it be like subtracting all the remaining interest from a mortgage amortization table right now, or including a present asset value on the future benefit payout from Social Security?

I am not completely sure I understand this question: "Wouldn't it be like subtracting all the remaining interest from a mortgage amortization table right now[?]" - I think future interest expense should be excluded from your balance sheet / net worth calculation.  Your balance sheet should include the principal balance of your mortgage only - whatever you could pay it off today for.  If you don't pay it off today, then the projected interest expense from the table becomes actual interest expense, but not before.

BINGO!

Likewise, deferred future tax liabilities are just as (un)certain. Sure you can calculate a number based on today's tax brackets, but Congress has changed those before, and they can change them again.

Likewise, I would hope my investments grow at a 7-10% rate or more, but would it really be useful to count that future growth in my net worth right now???

What is it called when two people who disagree each think a fact pattern supports their own assertion?

If you liquidate your mortgage today by paying cash to settle it, you will not have future mortgage interest expense, so do not include future mortgage interest expense in your net worth calculation.

If you liquidate your brokerage account today by accepting cash to settle it, you will have to pay the related capital gains tax liability, so include a deferred tax liability in your net worth calculation.

[NorCal]

It depends on what your purpose is.  If you want a value of your net worth, you should not add in any future tax liabilities.  If you want to discount future expenses, then you should also discount future returns on your portfolio.  You could do that math, but I don't know why you would.  The number would be relevant in an academic exercise, but real life would vary so dramatically as to render the calculation meaningless.

If your purpose is to determine what type of cash flow or withdrawal rate your portfolio can generate, you should absolutely consider the impact of taxes.  But this is an entirely different question, and has very little to do with net worth.

Using net worth as a rule-of-thumb for income is just that, a rule of thumb.  You need to do the actual math on what type of withdrawals can be made from your different accounts, and the associated impact on taxes and future flexibility.

[marty998]

A little O/T but even if you do crystallise a taxable gain, depending on the timing of that sale you can still defer paying the tax for well over a year.

For example we have a tax year end of 30 June. If I were to sell some shares on 1 July 2015 and make a capital gain, the tax liability doesn't fall due until 30 November 2016, a full 17 months later.

Just another strategy you can use to arrange you affairs to reduce your taxes.

[Cheddar Stacker]

The alternative view is that the expense occurs when the securities appreciate (creating an unrealized gain), and I think this is the view that GAAP accounting for businesses takes, that companies are required to record deferred tax liabilities against deferred / future / unrealized income.  I am personally pretty firm on the accounting theory that expenses can occur in a different period than a cash outlay.

This is true. Unrealized cap gains add to the value of your "Investment", you record the future tax from that gain as a liability, and you record the net gain directly into Equity/net worth.  It doesn't become income until you sell it.

But C-Corporations don't have a 0% cap gain tax bracket either. That was kind of my point above. You should have some ability to manipulate your taxable income and taxes once your wages disappear. If you record a liabilty for this on your balance sheet, please consider chopping it down by 50% afterwards due to the 0% bracket rules.

[slugline]

While recognizing that he's just a guy "occasionally typing some shit into the computer" I feel compelled to point out that MMM doesn't appear to be including deferred tax liabilities into his concept of net worth either:

http://www.mrmoneymustache.com/2015/01/26/calculating-net-worth/

NorCal brought up another example of the uncertainty you're wading into -- if you're going to count in your deferred tax liability (from 10 years in the future) in your present-day net worth, then you also have to be able to count the next 10 years of your investment gains/losses  in your present-day net worth.

I would probably enjoy coming up with a certain number for this liability as much as you would, but I feel like any number we come up with now is a lot like "hand-waving" one into existence to be honest.

[Davids]

Honestly I do not worry about any future tax liability in my net worth calculation. I stick with the numbers I see in front of me and that's it.