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is so beneficial to its users, as it allows after-tax money to compound for decades in the stock market, and then be withdrawn tax-free as long as the owner is 59-and-a-half years old.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.
Not a day goes by without bitcoin being in the news. And given the cryptocurrency’s phenomenal price rise, from zero to approximately $32,000 in a little over a decade, you – like many other individual investors – may be tempted to buy in. But how?
Actually, you can invest in finance’s newest asset via one of its most familiar vehicles: the IRA. Yes, you can buy bitcoin for a good old individual retirement account.
Cue the excitement? Maybe. In many ways, bitcoin investments are well-suited to an IRA. But, as with any investment strategy, there are pros and cons to consider.
What is a bitcoin IRA?
Bitcoin is a type of cryptocurrency (sometimes called a digital or virtual currency) – the oldest, and most popular of the dozen varieties available for trading and investment. So a bitcoin IRA is a type of investment retirement account that includes bitcoin within its portfolio.
Although these accounts may carry the name “bitcoin,” they also allow you to invest in other cryptocurrencies, like ethereum, litecoin, and bitcoin cash.
You can’t put bitcoin into a pre-existing, regular IRA that holds your stocks, bonds, ETFs, or mutual funds. Instead, you have to set up a special one, technically known as a self-directed IRA (SDIRA). The reason: The Internal Revenue Service (IRS) deems cryptocurrencies like bitcoin a type of property, which is off-limits to regular IRAs.
In some ways, bitcoin IRAs work like regular IRAs. While you can set one up with any amount of funds, they have annual contribution limits set by the IRS: You can only contribute $6,000 a year for 2020 and 2021 (or $7,000 a year if you’re age 50 or older). Any returns, income, or gains generated by the investments within them grow tax-free.
You can also establish a bitcoin IRA as either a traditional account (for which contributions are tax-deductible, and funds taxed upon withdrawal) or a Roth account (no tax break on contributions, but distributions are tax-free).
Of the two, the Roth version might have an edge, says Bogner, especially “if you are of the mindset that Bitcoin is going to explode” in price in the future. Roth IRAs are preferred by investors who project they’ll be in a higher tax bracket when they retire and start withdrawing money from the account. Since the Roth is funded with after-tax dollars, they won’t owe anything on their bitcoin gains – even if the currency has gone up 10 or 20 times.
How to buy bitcoin in your IRA
Bitcoin IRAs do operate differently in a few ways, though.
As the “self-directed” implies, these IRAs are directly managed by the account holder (as opposed to a financial advisor or money manager). And your regular brokerage, bank, or investment app probably doesn’t handle them. Self-directed IRAs are only available through firms that specialize in the type of asset you’re interested in.
So, to open a bitcoin IRA, you’d work with special custodians that can hold and deal in cryptocurrency. Some custodians require an application, walking you through the process. If you move forward, you can then fund these accounts via a rollover of funds from an existing IRA or another tax-advantaged account, or contribute new funds.
Some of the better-known, well-established custodians for bitcoin IRAs include:
This is still a young field, and information on a firm may be hard to come by. Frankly, some are little more than sales platforms. So, no matter which custodian you’re considering, be sure to do your due diligence on it.
Visit its website or call its customer service line to confirm and compare its fee structure, operations. Ask how your bitcoins will be stored, exactly, and about security procedures and measures – you don’t want your account holdings vulnerable to hackers.
Why invest in a bitcoin IRA?
There are plenty of positives to consider with bitcoin IRAs.
Portfolio diversification. Bitcoin tends to be “a great diversifier” for your financial assets, Bogner explains. Holding a bit of bitcoin “can be a good way to own something that doesn’t move exactly like the rest of your investments move,” she says. It could also be a hedge against inflation as the dollar’s value against some other currencies has declined.
The potential for great gains. While there have been bitcoin drops, there also have been returns that outpace other markets. If its history weren’t enough, the fact that only a limited number of bitcoins (21 million) can ever be mined suggests great future promise.
Positioning for a long-term hold. Though bitcoin fluctuates in price, it has generally trended up since its inception in 2009. Given its volatility, individual investors should consider it a long-term hold. That means it may be a good fit for an account that you don’t plan to access until retirement, anyway.
Demonstrated tax savings. The IRS taxes Bitcoin as an investment – it’s subject to a capital gains tax when you sell it at a profit. But not if it’s held in your IRA. That gain is tax-shielded, as any transactions within an IRA are. You only pay taxes on funds that you withdraw, when you withdraw them – in a traditional IRA; and never if in a Roth IRA (if you obey the rules).
Are bitcoin IRAs safe?
No investment is without risk. Potential issues also exist with bitcoin IRAs.
Responsibilities. While they’re called custodians, firms that offer self-directed IRA services – especially in the relatively young bitcoin IRA space – are not necessarily as responsible as conventional brokerages, registered investment advisors, and other financial services firms are. They are not overseen by regulatory agencies like FINRA, they are not SIPC-insured (reimbursing your funds if the firm goes under) and they are not bound by fiduciary rules that demand they put your interests first. In short, with bitcoin IRAs – as with any self-directed IRA – you’re solely responsible for making the decisions and taking on the risks of investing.
The financial takeaway
Bitcoin IRAs can offer an opportunity for investors who believe in the crypto’s future, but who want some tax savings along with their gains. Plus, the ease of dealing with a familiar type of account.
But there can be higher fees and account minimums when compared to other IRAs, so determine whether the trade-off is appropriate for you. Bear in mind that there are other ways to hold bitcoin, in regular accounts on crypto trading platforms like Coinbase and Binance US.
If you decide to open a bitcoin IRA, choose a custodian carefully. And only commit to bitcoin an amount that you can afford to lose, and think long term. Says Bogner: “Twenty years later, hopefully it’s worth more than what you put in.”
Saving and investing are the keys to long-term wealth. Unfortunately, “most Americans lack the discipline to save an adequate amount as a percentage of their income,” says financial advisor Sam Davis, a partner with TBH Global Asset Management. “So, inspiring savings early in a child’s life can really help.”
And one key tool to inspire: the Roth IRA. Because Roth IRAs allow for both tax-free growth and tax-free withdrawals, they offer a tremendous opportunity for young people. Kids have decades ahead of them to save for retirement. That puts them in the prime (and enviable) position to take full advantage of a long-term investment strategy, and the power of compounding.
Here’s why you should think beyond the usual savings accounts and savings bonds to consider opening a Roth IRA for your child.
Understanding the rules of Roth IRAs for kids
Anyone of any age can open a Roth IRA (more on how to do that later). And anyone of any age can contribute to a Roth IRA provided they have “earned income.” Earned income, as per the IRS, is money that can come from wages, salaries, tips, bonuses, commissions, and self-employment.
That’s to say your child’s weekly allowance does not count as earned income. Instead, think entrepreneurial activities like babysitting, lawn-mowing, dog-walking, or (for older kids) salaried jobs like being a lifeguard or working at a fast-food franchise. Office work at the going market rate can count too if you have your own company.
“We commonly see business owners use this tactic because they can put their children on the payroll,” Davis says.
How much can go into the Roth IRA? As much as the child earned – within limits. The regular IRA rules apply: For 2020 and 2021, you can contribute up to $6,000 a year.
The child needs to have earned income equal to the contribution amount. That means your child would need to have garnered at least $6,000 to make the full contribution. Otherwise, they can contribute up to the amount of money they actually made.
Anyone can contribute to a child’s Roth IRA
It can be difficult to convince a child to deposit their earnings into their Roth IRA. The good news is that it doesn’t necessarily have to be your child’s money that actually goes into the account. As long as your child meets the earned income requirement, you or anyone else can make the contribution – or a part of it – on their behalf.
“One idea that we’ve seen families implement that seems to be a good motivator is to implement matching funds,” says Davis. “Only invest for a child what they are willing to invest themselves.” So, for example, if your kid is willing to sock away $3,000, you can kick in another $3,000 to max out the contribution.
Normally, you can’t contribute to a Roth IRA if you make too much money: Above $208,000 annually (if you’re married) and $140,000 (if you’re single or head of household) in 2021. But in this case, no worries if your income is above the threshold. As far as the IRS is concerned, if your child has an IRA, it’s the child’s income that matters.
However, that cuts both ways. A key thing to remember is that you can’t invest a sum greater than the amount the child actually earned.
Roth IRA vs. traditional IRA for kids
You can adopt this strategy with a traditional IRA, too. But the Roth version makes more sense for young people for three reasons:
The child’s not likely to be earning enough to pay substantial income taxes. So getting to deduct the contribution when you make it – one of the big advantages of the traditional IRA – doesn’t mean as much.
With Roth IRAs, withdrawals are 100% tax-free after age 59½, when your child is likely to be in a higher tax bracket than they are now.
Overall, Roth IRAs are more flexible. You can withdraw Roth IRA contributions (but not investment earnings) at any time, tax-free and penalty-free. That means the child could conceivably use some of the IRA money for big expenses in young adulthood: college costs or a first-time home purchase. Some of these may qualify for exceptions that let you use earnings, too.
Another thing to keep in mind: Roth IRAs have no required minimum distributions (RMDs) at a particular age, unlike traditional IRAs. That means the account can continue to grow for an entire lifetime, making it an ideal wealth-transfer vehicle.
How to open a Roth IRA for your kids
If you’re ready to set up a Roth IRA for your kids (or grandkids, nieces, and nephews), the first step is to contact a brokerage that offers Roth IRAs for minors. Because the account is opened in the child’s name, you will need to provide their Social Security number. Some brokerages that offer IRAs for minors include:
Child IRAs work the same way as standard IRA accounts as far as the IRS is concerned. Of course, they are custodial or guardian accounts, which means adult custodian (you, presumably), control the assets in the IRA until your child reaches the majority age of 18 or 21 (depending on the state). After that, the account and all investment decisions are turned over to them.
Keep in mind that an IRA isn’t an investment itself; instead, it’s an account that holds the investments you choose, such as stocks, bonds, ETFs, and mutual funds. Again, this is your job as a custodian, until the child is old enough to take over.
The downsides of a Roth IRA for kids
One potential downside of a Roth IRA for kids is that your child may eventually make too much money to continue funding the account. Of course, that’s not necessarily a bad position to be in – and even without additional contributions, the account will continue to grow tax-free.
Another consideration: The account will be in the child’s control once they come of age. They can do whatever they want with it, and you won’t be able to stop them.
Finally, don’t think of this as a major estate planning tool/wealth transfer tool, Davis cautions. “For some families, it makes more sense to use trusts, family limited partnerships, and other advanced planning techniques when considering generational wealth matters.”
The financial takeaway
Setting up a Roth IRA for your kids now can help them secure a comfortable retirement later. By starting an IRA at a young age, your child can take full advantage of the power of compounding. After all, a single $6,000 investment made today could be worth more than a quarter-million dollars in 50 years, assuming an 8% annual return.
Moreover, a Roth IRA of one’s own can foster a lifetime of healthy money habits. “For many of our [clients], it’s a great way to help educate their kids on the savings process while investing tax-efficiently,” says Davis.