PayPal co-founder Peter Thiel has managed to grow a tax-free retirement account worth less than $2,000 in 1999 to $5 billion today, according to a report from ProPublica.
Citing a “trove of IRA tax return data” spanning more than 15 years, ProPublica has helped piece together how the country’s wealthiest people avoid paying taxes.
The Roth IRA was created by Congress in 1997 as a way for middle-class Americans to save for retirement independent of their employer. The retirement account initially had a $2,000 per year contribution limit.
Today, that contribution limit is $6,000, and American’s that make more than $140,000 per year are unable to contribute to the account.
That’s because the tax treatment of a Roth IRA account is so beneficial to its users, as it allows after-tax money to compound for decades in the stock market, and then be withdrawn tax-free as long as the owner is 59-and-a-half years old.
That sets the Roth IRA apart from a traditional IRA, which imposes a required minimum distribution that are taxed once the account holder turns 72 years old.
Thiel grew his fortune by using his Roth IRA account to invest in early-stage startups, which translated to massive windfalls when those successful companies went public years later. From there, Thiel was able to use that windfall to invest in more early stage companies within his Roth IRA account.
Thiel was able to put shares of early-staged startups in a Roth IRA account with the help of Pensco, a small firm that “allowed its customers to put nearly any investment they wanted into a tax-advantaged retirement account,” according to the report.
Pensco founder Tom Anderson told ProPublica that in 1999, Thiel and other PayPal executives wanted to put startup shares of that company into a traditional IRA, but Anderson steered them into the newly launched tax-free Roth IRA account.
“They immediately grasped that, and they did it,” Anderson told ProPublica.
The move was confirmed by Thiel’s 2005 New Zealand residency application, which stated, “Mr. Thiel purchased his founders’ shares in PayPal through his Roth IRA during PayPal’s formation,” according to ProPublica.
That move has payed Thiel handsomely. PayPal, which was acquired by eBay in 2002 for $1.5 billion and then spun out as an independent company in 2015, is now worth more than $330 billion.
According to ProPublica, Thiel paid just $1,700 for 1.7 million shares of PayPal in 1999. That’s less than the $2,000 Roth IRA contribution limit in 1999. Today, that stake would be worth $501 million.
But Thiel sold the PayPal shares in his Roth IRA following the eBay acquisition in 2002, vaulting his Roth IRA account to be worth nearly $30 million, according to the report.
Since then, Thiel has used his Roth IRA account to buy shares of Palantir when it was still private, along with other silicon valley startups. And in doing so, Thiel has managed to avoid paying a massive tax-bill, assuming he doesn’t withdraw money from his account prior to 2027, when he turns 59-and-a-half years old.
Roth IRA accounts offer tax-free growth on earnings and tax-free withdrawals in retirement, making it a popular long-term savings vehicle for anyone looking to build their nest egg.
Those perks, however, come with a big asterisk: You can’t contribute to a Roth directly if you exceed IRS-imposed income limits.
But people with high incomes still have a way into a Roth – a strategy that’s called a “backdoor Roth IRA.” Opening a backdoor Roth IRA gives high-income taxpayers a way to capitalize on the benefits of a Roth despite traditional restrictions.
According to CFP Brian Fry, a backdoor Roth IRA “is exactly what it’s called, a backdoor solution, but I would say it’s more mainstream than a backdoor or hidden thing.”
Opening a backdoor Roth IRA will lead you to the same flexibility and investment and trading options as a traditional IRA, without having to pay taxes when you withdraw money in retirement. It’s relatively easy to do, but comes with some tax implications to be aware of.
What is a backdoor Roth IRA?
Although opening a “backdoor” Roth IRA may sound shady, don’t let the name mislead you. It’s a totally legal loophole. At its core, a backdoor Roth IRA is a simple conversion: You put money into a traditional IRA or 401(k), then convert it to a Roth IRA.
Depending on your personal tax strategy, this could be a win-win situation, especially if you predict your tax rate will be higher in retirement.
Roth IRA accounts allow you to deposit money annually and pay income taxes the year the money is deposited. In contrast, a traditional IRA or 401(k) comes with an immediate tax advantage, because you are not expected to pay associated income taxes on deposits until the money is withdrawn. However, when money is withdrawn, you owe taxes on both their earnings and money that was initially invested.
To contribute directly to a Roth IRA, your income must be under a certain amount, determined by your modified adjusted gross income (MAGI). Individuals who earn above a specified income limit (based on taxpayer status) are prohibited from opening or funding Roth IRA accounts under IRS regulations.
If your income is too high to contribute to a Roth, going through the backdoor can be your way in, since the IRS does not limit who can convert a traditional IRA to a Roth IRA.
These accounts can be opened at banks and brokerages that offer IRAs. If your retirement plan is part of a 401(k) offered by an employer, the associated financial services company can also help you navigate the logistics.
It should also be noted that another option is to make an after-tax contribution to a 401(k) plan and then transfer those holdings to a Roth IRA.
Keep in mind that a backdoor Roth IRA isn’t a tax dodge by any means, but it does promise the future tax savings of your typical Roth IRA account.
Tax implications to consider
A backdoor Roth IRA comes with the tax perks of a Roth IRA, meaning you will not owe further taxes when you eventually withdraw money post-retirement. However, when opening a backdoor Roth IRA, you are subject to paying taxes on the money transferred in that tax year.
Fry asks clients to consider the following questions when deciding to open a backdoor Roth IRA:
“Where do I get the most value or the most tax-advantaged savings?”
“Does it make sense to get the tax deduction today if I potentially qualify?”
“Does it make sense to pay the taxes up front and have tax-free growth for potentially the rest of my life?”
“It’s really just about comparing your taxes today versus down the road,” Fry says, adding that “there’s not any significant advantages. In the end, Uncle Sam always wins.”
Disadvantages of a backdoor Roth IRA
While opening a backdoor Roth IRA is a solid option under some circumstances, it isn’t for everyone.
Individuals who will need to withdraw money in five years or less, for example, will not be able do so with a Roth IRA due to its five-year rule. Withdrawing early will subject you to taxes and a 10% penalty.
If you’re considering opening a Roth IRA, you should also be mindful of your tax bracket, staying alert to the fact that withdrawing too much at once may push you into a higher income tax bracket.
Finally, withdrawing money from your IRA to pay taxes limits future investment growth, and individuals who withdraw under the age 59-½ are subject to early withdrawal penalties.
The financial takeaway
A backdoor Roth IRA is not an official type of retirement account, but a way for high-income taxpayers to fund a Roth IRA despite exceeding traditional income limits. A backdoor Roth IRA is entirely legal and sanctioned by the IRS.
Although opening a backdoor Roth IRA comes along with initial taxes, it also gives investors the future tax benefits that come along with a traditional Roth account.