This is because a Roth IRA is a retirement vehicle meant for low and middle income Americans to accumulate tax-free wealth for the later years in their life.
It was never meant for a billionaire to accumulate billions of dollars in a vehicle that he will never pay income tax on.
In fact at the time Peter Thiel did this, you couldn’t contribute more than $2,000 to a Roth IRA and you could only do so if you were making less than $110,000 at the time (Now-a-days you can contribute up to $77,500/year via a mega back-door Roth IRA, but at the time this wasn’t possible).
Well at the time Peter Thiel was a founder of PayPal and was able to purchase $2,000 worth of shares in PayPal from within the Roth IRA vehicle.
Now keep in mind that Paypal in 1999 was not the giant payment exchange system it is today. It was the burgeoning days of the Internet and Peter Thiel was the founder of a company no one knew was going to actually make a lot of money one day.
So the shares were rightfully worth $2,000 at the time.
But Thiel believed that those shares would be worth a lot of money one day.
And he knew if he bought it within that tax-free vehicle that the future gains from that would all be tax-free.
So he purchased the shares from within the vehicle.
When Ebay ended purchased PayPal in 2002 for $1.5 billion, Thiel’s 3.7% share in the company was worth $55M.
A normal person would have paid taxes on the gain here of roughly $15M.
But Thiel owed nothing because the shares were bought within a tax-free wrapper.
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Peter Thiel's $2,000 Roth IRA contribution
So instead of having only $40M after-taxes to invest, he had the full $55M available to him. Thiel then used this $55M to make pre-IPO investments in companies that were worth nearly nothing when he acquired the shares but would in total end up being worth 100s of billions of dollars including companies such as Facebook, Stripe, AirBnB and more.
In other words, Thiel basically replicated his PayPal strategy except with other people’s companies—and all through his tax-free wrapper.
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Turning $2,000 into $5 billion tax-free
And ultimately he turned the $55M he got from Paypal into $5B of tax-free money that he will get in 2027 when he turns 59.5.
Financial Planning Takeaways:
So what are some lessons from Peter Thiel’s decision making process that the average reader here can walk away with?:
1) The value of proactive financial planning:
There are a million ways for wealthy people to benefit from our current tax system. I write about a lot of them. But you get more value by being proactive in your planning.
Peter Thiel could have not thought about any of this and just purchased his PayPal shares from a taxable account. Doing so would mean he’d have lost ~$2 billion in wealth relative to what he has today.
A little financial planning goes along way.
For those looking at starting businesses or potentially exiting them, the monetary value of proper planning is exponential if you do it before you exit vs waiting until afterwards.
2) The value of a self-directed Roth IRA:
The only reason Peter Thiel was able to do this is because he purchased the shares from a self-directed IRA. A self-directed IRA allows you to purchase alternative investments and private shares at your discretion from with a tax-advantaged wrapper. Peter Thiel could do this because the amount of shares he owned of the company was less than 10%. If he owned 100% of the shares of the company he would not have been able to do this (at least not according to today’s rules).
I’d add that if you are either an entrepreneur or highly compensated W2 employee, it’s also worth looking at Mega Backdoor Roth IRAs as a way of dumping a large amount of money into a tax-free vehicle.
3) A hedge against future tax-rates:
At the time Thiel purchased the shares the maximum federal and state capital gains tax rates was about 29% for California residents. Today it’s over 38%. So Thiel choosing a tax-free vehicle to house his investments at the time was not only a protection against the current tax rates of the time, but a hedge against future tax-rates.
What did Thiel miss?
The one part of financial planning that Thiel wasn’t able to protect against was the estate tax. The estate tax is a tax that is assessed on the death of an individual. Currently that tax-rate is 40%. So if Peter Thiel died today, before his beneficiaries inherited his $5 billion they would have to pay 40% of that (or $2 billion) to the government as a tax on the estate.
Once he turns 59.5 and has access to the money he will have to make some important decisions here:
1) Does he keep the money in the income tax-free vehicle and risk paying 40% or more in estate tax when he passes away? Or does move his money out of this Roth IRA into vehicles that will protect him and his beneficiaries from the estate tax going forward?
These are tough decisions. It really depends on how much he expects to spend in his lifetime versus how much he expects to pass on to his beneficiaries. Essentially the money he expects to spend during his lifetime should stay in the Roth IRA versus the money he expects to live past his lifetime should be moved into an estate planning vehicle.
I’ll be covering this in future articles.
But the important thing for readers to note here is that if you are the next Peter Thiel (or just an entrepreneur or someone with a high level of wealth) and are trying to do some proactive planning, there are strategies to use to get your money into vehicles that are protected against both income tax and the estate tax.
Because today Thiel could have purchased his PayPal shares from within vehicles that are protected from both. So instead of saving $2 billion in income taxes only to lose $2 billion to the estate tax, Peter Thiel’s money could have been protected against both and paid neither tax.
I will 100% be covering this in a future article.
About the Author
Rajiv Rebello is the Principal and Chief Actuary of Colva Insurance Services and Guaranteed Annuity Experts. He helps HNW clients implement better after-tax, risk-adjusted wealth and estate solutions through the use of strategic planning and life insurance and annuity vehicles. He can be reached at rajiv.rebello@colvaservices.com.
You can also book a call directly with him here:
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