IN AUGUST 2004, 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 10% 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. Unicorns don’t cross your path every day.
What I’m more interested in is the way Thiel made his investment, because that’s something that most people can indeed replicate. According to numerous reports, Thiel didn’t just write a check to Zuckerberg. Instead, he at least partially funded his investment using his Roth IRA—which means that portion of his gain will be tax-free.
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 upfront, but—in exchange for that—you pay no tax on withdrawals. In other words, if you put $1 into a Roth IRA during your working years and it grows to $5 by retirement, you’ll never pay tax on the $4 profit.
Below are some common questions about Roth IRAs. The numbers I cite apply to the 2017 tax year and are relevant to those rushing to fund a Roth before the April 17 tax-filing deadline. They change a bit for the 2018 tax year.
Can anyone open up a Roth IRA? The government does impose restrictions on eligibility. First, you need to be working and earning an income—or married to someone who is—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.
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. You may also be able to invest in a Roth at work—assuming your employer offers a Roth 401(k).
Can my child contribute to a Roth IRA? The short answer is yes, as long as your child has earned income. For example, if your teenager earns $3,000 from 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 teenager earning $3,000. 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 Roth. You could, however, simultaneously give your child $1,000 to help him or her make that contribution. That would be fine, because each year you’re permitted to make gifts of up to $15,000 to anyone without any tax implications, and that includes a gift to a child. I highly recommend this as a great way to get your children started on a lifetime of tax-free investing.
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. Your child, though, would need to file a tax return. But don’t let that deter you. On very minimal income, your child might owe little or nothing in taxes—and, if it allows your child to get started with a Roth, it might be well worth it.
What kind 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. But as the Thiel case demonstrates, 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? In theory, Washington could change the rules at any time. In reality, it’s hard to imagine that politicians would retroactively change 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’s worth looking into sooner rather than later.
Adam M. Grossman’s previous articles include On the Other Hand, Head Games and A Better Plan. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.