by Robert Rapier, Investing Daily
Article of the Week from Investing Daily
The Roth Individual Retirement Account (IRA) was created in 1997. The bill establishing this type of individual retirement account was sponsored by the late William Roth, a Republican senator from Delaware.
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A conventional IRA allows investors to save pretax money that can then grow until retirement. Taxes are assessed when the money is withdrawn.
With a Roth IRA, the contributions are post-tax, but then the account grows tax-free. No taxes are due when withdrawals are made as long as you meet certain guidelines.
For example, if someone makes $50,000 per year and contributed $5,000 into a conventional IRA, their taxable income base will be reduced by $5,000 when they file their tax return. For a single person making $50,000, they would have owed about $1,100 in taxes on that $5,000, which they managed to avoid in the year they made that contribution. So, instead of having $3,900 after-tax in their pocket, $5,000 goes into the IRA and grows until retirement.
In the same scenario, a person wishing to make a $5,000 contribution into a Roth IRA will get no tax deduction at the time of the contribution. The $1,100 in taxes on that amount must be paid for that tax year.
There are pros and cons with each approach. Either investment vehicle can be a great way to save for retirement.
Peter Thiel’s Roth IRA
The Roth IRA is not a fast-track to accumulating a billion dollars, unless you happen to be PayPal (NSDQ: PYPL) cofounder Peter Thiel.
Last week Propublica reported that Thiel had turned a $2,000 Roth IRA contribution in 1999 into a whopping $5 billion in 2019. That’s a jaw-dropping achievement, because the average Roth IRA across all age groups has a value of about $40,000. So, we need some context on how Thiel did this.
First is the question of how a billionaire managed to contribute to a Roth IRA, since there are income limits. Apparently Thiel only earned about $73,000 in salary at PayPal in 1999, with most of his compensation coming in the form of stock. Thus, he met the income limit in 1999 for contributing to a Roth IRA.
For perspective, if you had invested $2,000 in a Roth IRA in 1999 and earned the average long-term performance of the S&P 500, you would have about $14,000 in 2019. How did Thiel manage to grow his account to more than 360,000 times that amount?
Thiel utilized a self-directed Roth IRA, which lets you hold alternative assets that you generally can’t invest in through a regular Roth. Note that while this type of Roth IRA is available to regular investors, this is not the type of IRA you would establish at Fidelity or Vanguard.
You must first find a custodian that will agree to hold the account for you, but then a self-directed IRA enables investors to invest in things like real estate or a privately held company. Those assets are not available for investment by conventional IRAs.
As a founder of Paypal, Thiel was able to purchase 1.7 million shares of Paypal at 1/10th of a cent each (for a total of $1,700). Once Paypal went public, the value of Thiel’s shares exploded. Today, Paypal shares trade at $290 a share, which is nearly 300,000 times the price Thiel paid for them.
Reforms May Come Next
The average investor doesn’t have access to this kind of sweetheart deal, thus most investors would be unable to achieve what Thiel did. Further, nothing angers the public and politicians more than seeing billionaires avoid taxes. The Roth IRA was set up to help average investors save for retirement, but Thiel’s case is seen largely as one where a billionaire used a sweetheart deal unavailable to most investors to escape billions of dollars in taxes.
Democratic Senator Ron Wyden of Oregon has proposed capping Roth IRAs accounts at $5 million and forcing owners to withdraw anything over that amount so that it could be taxed.
You can expect Thiel’s Roth IRA to generate some interest in Congress, and it could lead to reforms in the Roth IRA that would prevent this sort of outcome. But, for the majority of us, such reforms are unlikely to cause any issues.
Caption graphic photo credit: Peter Thiel (1914), Clip from Dan Taylor, Heisenberg Media via Wikipedia CC BY 2.0. Full image:
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