Taxes on the Seed or the Crop? What we can learn from Peter Theil’s Roth IRA
A story recently hit the news that surprised even me. It was reported by ProPublica, that an investor has amassed over $5 billion in type of retirement account called a Roth IRA. If you haven’t heard of him, the person was Peter Thiel, an early investor in companies like PayPal, e-Bay and Facebook and reportedly turned an initial $2,000 investment into $5 billion.
This was a large part of my surprise because Roth IRA’s have relatively low contribution limits, and high-income earners are generally excluded from this type of account. Also, the contribution limits from its creation in 1998 until 2008, was less than $5,000 per year (it was $2,000 when he contributed) making it nearly impossible to build an account this large in such a short time.
As incredible as all that is, here’s the real kicker - under current tax law, every bit of the $5 billion will be available to him TAX FREE at age 59½!
As you might imagine, much is being made of the “fairness” of this as many people feel this is just another multi-billionaire who is not going to pay his fair share. I won’t wade into that here, but the truth is, most people in the U.S. can also take advantage of both the tax-deferred growth potential and qualified tax-free withdrawals when you invest in a Roth IRA.
Roth IRA basics
The Roth IRA was created in 1997 and was named after Sen. William Roth. It provided an alternative to the Traditional IRA in that with a Roth IRA, the contributions are not tax-deductible. But any growth and the eventual distributions are tax free if certain rules are followed.
This includes not withdrawing any of the growth in the first 5 years from the time the account is established and funded - and you’ve reached age 59½. However, the amount contributed can be withdrawn at any time tax free as the contributions have already been taxed. So, in Mr. Thiel’s case, he can remove the original $2,000 contribution, but can’t withdraw the growth without taxes and penalties until he’s 59½ (he’s currently 53).
The 2021 contribution limits are $6,000 per year if you’re under age 50, $7,000 if you’re 50 and over.
Also keep in mind there are income eligibility restrictions that must be met for you to contribute for that tax year. For single tax filers, your Modified Adjusted Gross Income (or MAGI) for 2021 must be under $140,000 and for married filers it’s $208,000.
Who can benefit
If you have access to a 401(k) or certain other retirement plans with your employer (even if you’re not contributing), if you’re income is too high you may lose the deductibility of a Traditional IRA.
For those who do fall into this situation but have additional dollars to invest over and above the 401(k) limits, a Roth rather than a Traditional IRA may still provide significant benefits.
As long are your income is under the thresholds, even if you have access to and are maxing out your 401(k) contributions, you can still fully contribute to a Roth IRA, giving you another way to potentially grow your investments tax-free over time.
For those who qualify for both a Traditional and a Roth IRA, often the question is which one should they choose. Generally, it comes down to this - would you rather pay taxes on the “seed” or the “crop”. In other words, do you want your tax break now or later, and which would be the most advantageous for you? Again, generally the younger you are and the lower your income, the more advantageous a Roth IRA would be. Presumably, you would have more time for your contributions to compound, and the lower your income, the less likely you need the tax deduction up front. But even though you lose the tax break up front, as Mr. Thiel now knows, you would receive your tax break later and it could be quite significant.
So, back to the concept of the seed or the crop. Peter Theil may have forfeited the tax deduction on the seed, but now what a tax-free crop!!
Michael P Henderson, CFP® CKA® Founder | CERTIFIED FINANCIAL PLANNER™
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their product or services.
All investing involves risk including loss of principal. Unqualified Roth withdrawals may result in a 10% IRS penalty
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Crossover Point Advisors, an SEC Registered Investment Advisor and separate entity from LPL Financial.