Why Your Personal Balance Sheet is a Liar When It Comes to Your Retirement Accounts

A balance sheet is one of the basic financial statements that can be useful in many situations. Unfortunately, when it comes to retirement accounts, balance sheets can be extremely misleading.

In its most basic form, a balance sheet lists your assets, and, from that total, subtracts any liabilities you have to arrive at your net worth. Presumably then, by comparing the net worth statements of two people, we should be able to look right to the bottom number – the net worth – and see who is currently “worth more”... solely from a monetary view of course.

For instance, below is a simplified balance sheet for a fictional person, John Doe.

Note that John has total assets of $1,112,500, from which $19,000 of liabilities were subtracted to arrive at his net worth of $1,093,500. Not too shabby!

What if we now imagined that John had a twin sister, Jane, who's financial life has mirrored John’s in almost every way. What if I told you that the only difference came down to their homes, and whereas John has no mortgage and a home valued at $500,000, Jane’s home is valued higher, at $600,000, but she has a $350,000 mortgage. All things being equal, who would you rather be?

Chances are, you’ve said John, which is certainly who I would choose. As you can see from the simplified balance sheet below for Jane, her net worth is “only” $843,500 compared to John’s of $1,093,500. That’s $250,000 less, even though her home is worth more than John’s.

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So what does any of this have to do with retirement accounts you ask? Well, simply this. If you chose to be John over Jane in our previous example, it’s because you recognized that the liability attached to Jane’s home made it less attractive, and she was, from a financial point of view, worth less.

But what if we shook things up here and added another sibling to the mix, Sally Doe. Sally’s financial life has also mirrored John’s closely. The only difference between them is that instead of having a $225,000 traditional IRA balance, she has a $200,000 Roth IRA balance. My question, once again to you, is who would you rather be?

Here’s the crazy thing, if you said Sally – whom I would certainly choose by the way – you are actually choosing the person with a lower net worth! As you can see from the Sally’s simplified balance sheet below, her Roth IRA and John’s traditional IRA are viewed, by the balance sheet, as equivalent.

How can a traditional IRA that’s embedded with what could be a significant tax liability be viewed exactly the same as a Roth IRA that’s growing tax free for your entire life? It shouldn’t be, but on this particular statement, they are. Just ask your mortgage broker the next time you see him whether he’d rather see a $100,000 bank account and a $200,000 IRA, or a $50,000 bank account and a $200,000 Roth IRA. If you’re in the 25% tax bracket, they should be treated as roughly equivalent, but they’re not.  And that’s why, when it comes to retirement accounts, your personal balance sheet can lie to you.