In August of 2004, Silicon Valley venture capitalist Peter Thiel sat down to listen to a pitch from a 20-year-old entrepreneur named Mark Zuckerberg. It didn’t take long for Thiel to make up his mind. According to most accounts, they met in the morning and, after a short break for lunch, Thiel committed to buying ten percent of Zuckerberg’s new company, Facebook.
In hindsight, this was clearly a smart move, making Thiel a billionaire. But, while it was certainly a great investment, it was also an unusual opportunity, one that would be hard to replicate. Unicorns just don’t cross your path that often. What I am more interested in is the way in which Thiel made his investment, because that is something that most people can indeed replicate. Specifically, according to numerous reports, Thiel didn’t just write a check to Zuckerberg. Instead, he funded his investment through his Roth IRA (Individual Retirement Account), and that’s the part of the story that is worth understanding.
A Roth IRA is a relatively new type of retirement account. Created by the government in 1997, Roth accounts offer savers an unusual tax benefit. In contrast to traditional retirement accounts, which offer a tax deduction on contributions but impose a tax on withdrawals, Roth accounts are the reverse: There is no tax deduction up front, but in exchange for that, you pay no tax at all on withdrawals. So, if you put $1 into a Roth IRA during your working years, and it grows to be worth $5 when you retire, you’ll never pay any tax on that $4 profit. This apparently is what Thiel did when he invested in Facebook, and that is why Roth accounts are so attractive.
Below are some commonly-asked questions about Roth IRAs.(Keep in mind that everyone’s situation is different, so please be sure to consult your tax advisor before making any decisions. Also, the numbers I cite below apply to the 2017 tax year. They will change a bit in 2018.)
Can anyone open up a Roth IRA?
The government does impose restrictions on eligibility. First, you need to be working and earning an income, and there are also income limits. If you are single and your income is below $118,000, you can contribute as much as $5,500 per year (or $6,500 if you are 50 or older). If you are married, the income limit is $186,000. That said, even if you are above these income thresholds, the government does still provide a way to contribute to a Roth; it just takes a little more work.
Can my child contribute to a Roth?
The short answer is yes, as long as your child has income. For example, if your child earns $3,000 at a summer job, he or she could contribute up to $3,000 to a Roth, but not more.
Can I contribute to a Roth for my child?
No, not directly, but there is a way to effectively accomplish the same thing. Let’s take the case of your child earning $3,000, and suppose you wanted $1,000 of that to go into a Roth in the child’s name. Technically, your child would need to make the contribution to his or her own Roth. However, you could simultaneously give your child $1,000 to help them make that contribution. That would be fine because you are permitted to make gifts of up to $14,000 to anyone without any tax implications, and that would certainly include a gift to your child. I highly recommend this as a great way to help children save.
What if my child’s income is informal, from babysitting, for example?
Even if your child is paid in cash for occasional work, he or she would still be eligible to contribute to a Roth. Importantly, though, your child would need to file a tax return. But don’t let that deter you. For very minimal income, your child might owe zero, or very little, tax. And, if it allows your child to get started with a Roth, it might be well worth it.
What kinds of investments can I make inside a Roth? I’d like to do what Peter Thiel did.
A Roth account is just like any other investment account, meaning that you can purchase standard, publicly-traded securities, such as stocks, bonds or mutual funds. If you wanted to invest in more unusual assets, such as real estate or private companies, you would need to do it very carefully because a number of specific restrictions apply. As the Thiel case demonstrates, however, it absolutely can be done.
Do I have to take distributions from my Roth when I retire, like I do from a traditional IRA?
No. This is another great benefit of Roth IRAs.
Could the government ever change the rules on Roth IRAs?
Yes, in theory Washington could change these rules at any time. In reality, it is hard to imagine that they would make a retroactive change to existing Roth IRAs. It is conceivable, though, that they could limit, or even discontinue, future contributions. For that reason, if you are thinking about establishing a Roth, it is worth evaluating sooner rather than later.