The road to financial independence is different for everyone, but the starting point is the same: your personal balance sheet. It allows you to move toward financial independence — the place where you have enough assets to live comfortably in retirement yet provide for your heirs.
In this article, we’ll discuss why developing and maintaining a personal balance sheet is so important and how it can position you for success today, tomorrow, and beyond.
What exactly is a balance sheet?
Put simply, it’s a summary of all the assets you own as well as an overview of your liabilities or debts. It’s often known as a “net worth statement.”
Why is developing a personal balance sheet so important?
For a business, having an up-to-date balance sheet is expected. After all, it’s the starting point for making most decisions. The same should be true of a personal balance sheet, as it’s the only way you can effectively manage the overall financial health of your family. However, most people don’t think about their personal wealth this way.
A personal balance sheet acts as a picture of where one’s finances stand at a particular point in time. It’s a way to identify potential financial issues and set financial goals. When used year over year, it becomes a calibration tool that helps you track your progress toward financial independence.
While many people who don’t have a current balance sheet can tell you within a pretty small margin of error what they own and owe, they’re often surprised by what their personal bottom line adds up to and, more importantly, what it all means.
When used year over year, it becomes a calibration tool that helps you track your progress toward financial independence.
For example, we have clients who know they have a nice home, a vacation home, and a successful family business. They don’t know, however, where the cash will come from to pay their estate taxes if they die or how they’ll support their lifestyle should they become disabled.
How does a personal balance sheet influence estate planning?
From an estate planning perspective, oftentimes merely changing the ownership structure of certain assets can save significant dollars in estate taxes. This is the kind of thing that isn’t immediately obvious without a personal balance sheet.
Consider that the number-one legacy people most want to leave isn’t financial assets but family harmony. People don’t always realize how certain assets they cherished during their lifetime — family cottages, for example, or sentimental family heirlooms — may cause tension and frustration when they’re no longer around. The same can be true of family businesses when some family members are actively involved and some aren’t or when future leadership of the business hasn’t been clearly identified. These items aren’t easily divisible. Thoughtful planning could eliminate or at least reduce the possible loss of family harmony.
There are insurance concerns, too. Due to estate tax limits in place, many people discover they no longer need insurance for the reason they initially purchased it. But decisions about insurance, like any other financial discipline, can’t be made in a vacuum.
How will a personal balance sheet affect your financial decisions?
Your balance sheet brings context to decisions. It allows you to understand how a decision in one part of your financial life, like insurance, affects other parts of your financial life like taxes.
Estate planning, investment management, insurance purchases, and tax — none of these items can stand alone. They must be considered together. For example, if all you’re focused on is a tax return, the goal is to decrease your taxes, whereas the ultimate goal should be determining how to increase your net worth.
Ask yourself, “Does this plan, strategy, or decision positively or negatively affect my net worth?” Sometimes, it’s okay to pay taxes if it positions you for even greater long-term growth.
From an investment perspective, it’s the starting point for identifying potential gaps in your investment strategy. For example, clients often think they’re well-diversified because they have accounts in many places, but after preparing a balance sheet, they find that all these accounts are actually invested very similarly. It helps to diversify your investments, thereby significantly reducing your portfolio volatility.
How do you prepare a balance sheet?
There are two phases: gathering the data and assembling it into a format. Gathering the data can be challenging, especially for people doing it the first time. They always forget something, but it’s better to start the process and refine it as you go along as opposed to doing nothing and simply hoping for the best.
We always let our clients know that starting doesn’t have to be hard. In fact, we can begin a personal balance sheet for a client with only a tax return. It’s a process that takes a while to get right, but having your tax return is a start.
Oftentimes, the most difficult part of the balance sheet is determining the ownership of individual assets, particularly if someone hasn’t reviewed an asset in a long time. People often make decisions during a marriage regarding titling that go unchanged after a divorce. It’s important to stay on top of these things.
That’s why developing the balance sheet is critical, but it’s even more important to review it regularly and keep it current.