Net Worth of Money in IRA vs Roth vs Cash

Question

Consider three people:

• Person A has $1,000,000 in cash.
• Person B has $1,000,000 in an IRA or 401(k).
• Person C has $1,000,000 in a Roth IRA or Roth 401(k).

I assume Person A has a higher net worth than Person B, since Person B has a future tax liability when money is withdrawn from the IRA, and Person A does not have this tax liability. (From a financial perspective, I would certainly prefer to be Person A rather than Person B.)

I assume Person C has a higher net worth than Person A, since earnings on Person C's investments will not be taxed, while earnings on Person A's investments will be taxed. (From a financial perspective, I would certainly prefer to be Person C rather than Person A.)

How should Net Worth for these three people be computed to take future tax liability into account? Or, would these three people really have identical Net Worth?

Answer 1

As far as the traditional definition of net worth, all 3 have the same number. However, you touch on an important point, and it'd be more useful to think of net worth as the after-tax amount of money you have available to spend.

To do this, you'd need to estimate expected capital gains and dividend taxes for Person A, and the average withdrawal tax rate for Person B. Person C would likely have no tax liability at all, and could consider 100% of their balance as after-tax dollars.

This takes a bit of guesswork, since capital gains could turn into losses, and it's hard to predict what the income tax rates will be in 40 years. However, after-tax dollars are the only "real" money you can take to the grocery store, so I personally use these adjustments to get a clearer picture of my net worth.

Answer 2

All three people have the same $1,000,000 on a financial statement but AFAIC, their net worth and financial circumstances are different.

Person B has a tax liability. The amount of that liability is unknown because the tax bracket at the time of withdrawal is unknown. He certainly is worse off today than Person A because Person A's money is unencumbered.

Person C may or may not be in the same situation as Person A because Person C's money may be restricted (under age 59-1/2 and/or the 5 year restriction due to an IRA conversion).

In terms of today:

• Person A is equivalent to Person C if there are no restrictions on Person C's ability to withdraw money.

• Person B is inferior to Person A or Person C due to the Person B's tax liability

In terms of the future investment growth, like you, I'd rather prefer to be Person C rather than Person A.