Last month, the website ProPublica broke a story about Peter Thiel’s $5 billion Roth IRA. Personally, I found the article fascinating, but probably not in the way the authors intended. They seemed intent on stoking flames of moral outrage (How dare someone turn a $2,000 Roth contribution into a $5 billion fortune!). Instead, it kindled in me feelings of deep admiration.
Individual retirement accounts (IRAs) are a wonderful way to save for retirement. According to the Investment Company Institute, Americans had $12.6 trillion invested in IRAs at the end of the first quarter. Most IRAs are invested in mutual funds and publicly traded individual stocks and bonds. However, a growing number of investors are using “self-directed” IRAs to invest in other assets, including real estate, limited partnerships, LLCs, and stock in private companies — even start-ups. In this, as in so many things, Peter Thiel was ahead of the curve.
In 1999, Peter Thiel was not a wealthy man. According to the ProPublica article, his reported income for the year was a relatively modest $73,263. However, that was the year Thiel and some friends launched a company that came to be known as PayPal using funds from their newly-opened self-directed Roth IRAs.
Thiel’s decision to use his Roth IRA to buy his founder’s shares was a masterstroke. The dot-com rally was in full swing and it didn’t take long for the value of those shares to soar. But PayPal’s success was not a foregone conclusion. The tech sector came under intense pressure in 2000 and most of those late-1990s start-ups failed. However, PayPal survived and by the end of 2002 Thiel’s Roth was worth $28.5 million. Other investments followed, including a significant early stake in Facebook, and Thiel’s Roth IRA grew and grew.
Some people look at Thiel’s $5 billion Roth IRA and conclude the system is broken, but I don’t. The system is working just fine. Every tool Thiel used to amass his fortune is available to each of us and we can have similar results if we have the same vision, smarts and luck that he had.
But take care. Investing in non-public assets in a self-directed IRA is tricky. If you are going to go down this path, you will need a good advisor and a capable IRA custodian to help you keep from running afoul of the arcane prohibited transaction rules.
For example, while you can use IRA funds to invest in private company stock, you cannot buy stock in S corporations. And while you can buy certain coins that are purchased primarily for their precious metals content, you cannot buy other coins that are purchased as collectibles.
You also cannot engage in certain transactions with people known as “disqualified persons.” Disqualified persons include any fiduciary to the IRA (including the IRA owner), members of the IRA owner’s family (spouse, ancestor, lineal descendant or spouse of a lineal descendant), or a corporation, partnership, trust or estate where 50% or more of the shares, profits or beneficial interests are owned by any of these. An officer, director, or 10%-or-more shareholder or partner of one of these entities is also a disqualified person.
If you own real estate in your IRA, you cannot hire a disqualified person to manage the property or to fix it up. In fact, you can’t even let them do it for free. Instead, you must hire an independent person to do the work and pay her from the IRA itself. If you pay for the service on behalf of the IRA, the payment would be a prohibited transaction or could be deemed a contribution to the IRA.
The IRS levies steep penalties on prohibited transactions. The standard penalty is a tax on the disqualified person engaged in the prohibited transaction equal to 15% of the transaction amount. If the transaction isn’t promptly corrected, the penalty increases to 100%. In addition, the IRA will also face a penalty, usually equal to 100% of the transaction amount. If the disqualified person is the IRA owner or one of the beneficiaries, the penalty is even more draconian. In that case, the IRA itself is fully disqualified, meaning the entire IRA is deemed to be distributed and the IRA owner is immediately liable for taxes on the entire IRA amount.
Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.