Dear Clients and Friends,
On July 24th, ProPublica wrote this article about how Peter Thiel, most notably known as the founder of PayPal, turned a $1700 investment in a Roth IRA into $5 billion, which, once he turns 59 ½, can be accessed tax free for the rest of his life. Since then, numerous publications and blogs have released articles about how you can do this yourself. Inevitably, many clients have emailed and called asking about this topic. For today’s weekend reading, we will share a primer on both traditional and Roth IRAs, and we will also dispel popular myths surrounding how to use them to become a billionaire.
First, how did Peter Thiel turn $1700 into $5 billion? When PayPal was first founded, he bought 1.7 million founder’s shares of the company for fractions of a penny each. Each of those shares now trades in the upper $200 range. Like most successful investments, he invested early at a low cost and saw his investment grow exponentially as the company became successful. So why doesn’t he have to pay any taxes?
The answer to this lays in the difference between traditional IRAs and Roth IRAs.
When you contribute to a traditional IRA, you may take a tax deduction for your contribution if you are under a certain income limit. This lowers your tax liability, allowing you to take and invest your tax savings each April and earn compounding returns on those dollars. On the flip side, any money that you take out of your IRA in retirement, as well as the earnings on that money, will be taxed. This is important; we will come back to this point later. The theory here is that you are deferring a portion of your taxes during your earning years, when your tax rate tends to be at its highest, and you are paying it during your retirement, when your tax rate tends to be lower. Makes sense, right? So why all the fuss about Roth IRAs?
The first difference with Roth IRAs is that you do not take a tax deduction on your contributions. This means you are paying more taxes now than you would if you made a deductible traditional contribution. Your money will still grow tax deferred within the Roth IRA, as with the traditional IRA. However, the real difference comes when you take distributions from a Roth IRA. So long as you have had the money in the Roth IRA for 5 years and are older than 59 ½, you may take withdrawals tax free from your contributions and earnings within the Roth IRA. This is where Peter Thiel’s strategy really made a difference. All his growth came after the funds were already in the Roth IRA. Furthermore, while the IRS has rules forcing you to start taking distributions from traditional IRAs at a certain age, there is no such requirement for Roth IRAs. This is because you have already paid your taxes on the money, so they do not care what you do with it from there.
So, does this mean that everyone should drop what they are doing and start putting as much money as they can into penny stocks within a Roth IRA? Absolutely not! Sure, this is probably your quickest way of turning a few thousand dollars into a billion, but it’s more likely to be the quickest way to turn a few thousand dollars into nothing!
The truth is that everyone’s financial situation is different. Everyone has different tax rates, cash flows, retirement goals, investment horizons, etc... and no blanket strategy will ever be appropriate for everyone. We have already seen do-it-yourself investors make very poor decisions regarding Roth vs. traditional contributions after reading the article above. The truth is Roth and traditional IRAs are both very powerful tools that investors have in their toolbelt, and when implemented properly, they can substantially increase the success of one’s retirement plan.
With that, we wish you all a very lovely weekend,
Daniel Levinson, CFP®
Financial Planning Associate
MOR Wealth Management, LLC
1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930.8303 | c: 856-906-4888 | f: 267.284.4847 |
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