By Lee Sherman
PayPal founder and Silicon Valley gadfly Peter Thiel famously turned an investment of just under $2,000 in a Roth IRA in 1999 into a fortune of $5 billion. Could you do the same?
That depends. Financial advisors universally recommend Roth IRAs to their clients because they are a good way to build a nest egg. But wealthy investors have found that they can be used in ways that go far beyond what they were originally intended for.
ProPublica reported that Thiel didn’t add a single dollar to his initial investment. So what did he do right and what are the potential pitfalls of his strategy?
The Roth IRA’s hidden little secret
A normal retirement plan such as a traditional IRA or 401(k) defers taxes until the time the money is withdrawn from the account. With a Roth IRA, you are taxed upfront on the money you deposit in but once that money is in your account, it grows tax free and you aren’t taxed on withdrawals.
Roth IRAs were originally designed to help the average working American save for retirement but ultra-wealthy individuals like Thiel, Warren Buffet, and others have found a way to use them to their advantage. Thiel is notoriously tax-adverse and how he managed to achieve this feat comes down to the following four seemingly simple (and perfectly legal) steps.
- Get in on the ground floor of a internet startup with the potential to one day become a unicorn (reaching a $1 billion valuation). Thiel co-founded PayPal.
- Buy a huge number of shares at a rock-bottom price. Thiel spent $17,00 for 1.7 million shares at $.001 per share.
- Hang onto the stock until age 59 and a half.
- Use the proceeds (which remain tax-free) to make additional investments. It took under a year for the value of Thiel’s PayPal shares to increase in value from $1,664 to $3.8 million and he reinvested the profits.
Let’s be clear. Thiel could pull this off because of his connections and status as a successful entrepreneur. He didn’t start out as a billionaire but the kind of deal that led to his fortune isn’t necessarily available to most working Americans. In 1999, when Thiel made his initial $1,700 deposit, single taxpayers were only allowed to contribute to a Roth if they made less than $110,000. IRS records show that Thiel’s income that year was just $73,263. $2,000 was also the maximum amount that you could deposit at the time.
Thiel didn’t do anything illegal. Startups typically offer their top execs low salaries and a pile of stock options. He merely seized an opportunity to invest in PayPal at an extremely favorable price.
As is true with so much in life, success begets additional success. Thiel is also a savvy superforecastor with an uncanny ability to hunt down unicorns. Because there is no limit to the amount of money that can be stashed tax-free, wealthy investors like him are able to use these accounts as tax havens again and again.
And financial advisors still recommend a balanced portfolio made up of ETFs, index funds, mutal funds, and individual, publicly traded companies. investing in the open market is less certainly less risky than trying to spot a unicorn in the wild.
But, if you work for a startup, purchasing your options is a low-cost way to contribute to a Roth IRA. Or you may be able to receive advisory shares in lieu of compensation for consulting. It’s all about the math. Remember, with a Roth IRA, you are taxed once, as a percentage of the initial deposit. The miracle of compound interest combined with the fact that you aren’t taxed again when you take the money out can lead to exponential growth in your portfolio.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.