Driving a Truck Through It
Vol # 44 - June 25th, 2021
Retirement accounts are where the vast majority of Americans save the vast majority of their money. These tax incentivized vehicles provide several different benefits to workers putting aside a piece of their paycheck today, to fund the next act of their lives.
The average 401(k) balance is a little over $130,000 - including all of the investors who are just getting started. There are a few million retirement account millionaires - Fidelity alone has almost 750,000 as of the first quarter of this year.
And there’s at least one retirement account billionaire. Peter Thiel had ink spilled all over his balances in a ProPublica article earlier this week crowning him “Lord of the Roths”.
The Roth IRA is a particularly interesting vehicle to accumulate wealth because of when you pay your taxes. Contributions are made with after-tax money (unlike a 401(k) which is pre-tax), and earnings not only grow tax free, but they are not taxed at all if withdrawn after age 59 ½.
There are contribution limits on how much an individual can put into these accounts, and income eligibility requirements that generally prevent them being abused as a tax shelter by wealthy savers.
While most people typically use their IRAs to buy mutual funds, stocks, and bonds, there are also more creative use cases. With a self directed IRA you can buy real estate, bitcoin, and even shares of private companies.
Peter Thiel made his IRA balloon through the purchase of the earliest possible stage of equity - founder’s shares. When launching his company, he purchased 1.7M shares of PayPal at $.001 - 1/10th of a cent - for a total Roth contribution of $1700 in 1999. He never again contributed.
PayPal soon became a household name and was bought by eBay in 2002. The IRA was then worth about $28.5M - an impressive balance, but less than half a percent of what it would eventually grow to. Thiel didn’t stop here - founders found, and money makes money.
Data behemoth Palantir was formed shortly after in 2003, where he also bought equity in his IRA. They’re now a $50B company. Another of his IRA investments? Facebook - where he was the first $500,000 check into the company during Mark Zuckerberg’s infamous summer away from Harvard.
What made these investments even more impactful is that as Thiel rolled one into another, they were free from capital gains tax. If done outside an IRA, the PayPal shares he first bought would have been subject to a tax bill upon sale, before the reduced proceeds could be invested elsewhere. Because they were in an IRA, the tax free gains could continue to compound.
So what are the lessons that can be drawn from this? Are we really surprised that a clever entrepreneur with a particular distaste for taxes found a legal way to maximize his investment revenue?
The first thing that’s important to note here is that each of these investments happened to work out particularly well for Thiel. His access to, and penchant for building winners would produce enviable returns, even if they were taxed. Having the conviction and foresight to found multiple billion dollar companies, and also identify others is what is most unique here.
The second is the importance of compounding, and time in the market. Taxes are a big friction to compounding wealth. Jumping in and out of investments not only has all the risks of market timing, but puts you in a disadvantageous tax position.
Time on the other hand is one of the biggest tailwinds. Letting your winners run over extended periods produces sizable returns. It took 12 years for Theil’s account to grow to $1B. It only took 8 more for that to rise to over $5B. 80% of the value has been created in the last 40% of the time.
There’s also a word of caution to be heeded about the concentration of this investment strategy. Most people would do better to simply buy diversified, low fee vehicles that track market indices. Putting all your eggs in one basket has the potential for a very high payout, but it comes with commensurate risks. Perhaps 20 years hence we’ll read about the IRA billionaire who seeded the account with Gamestop and AMC, but few would recommend this strategy.
Despite the fact that Thiel made several very successful investments, there’s something that still may feel unsettling about a billionaire using the middle class retirement tool as a tax sheltered investment vehicle.
There’s a lot that’s wrong with the current tax code. Whether it’s carried interest or the mixed straddle, cunning investors will always find ways to reduce their tax burden. The real estate industry has its own version of perpetual motion tax free shelters with the 1031 exchange.
What Thiel and a handful of others have done takes a small loophole and driven a billion dollar truck through it. Was this what Senator Roth intended when he proposed the legislation back in 1998?
While Thiel and company might be in the hot seat now, millions of other Americans use these same rules to manage their savings to make every penny count. 40% of workers over the age of 65 have previously retired, and additional income is the primary reason for their return.
Regulating based on specific outcomes carries a lot of risk. Caps on how much is too much become arbitrary. Narrowing the opportunities for savers makes the already precipitous path to a comfortable retirement even steeper. Despite recent bumps due to the pandemic, American household savings rates have been on a multi-decade decline.
Outlandish numbers like $5B in a Roth IRA invite a knee jerk reaction. There’s no question we need to see another Showdown at Gucci Gulch. We can hope that our legislators take an even handed approach to updating incentives, but we can take investing lessons away today.
Put yourself on the side of compounding, and reduce frictions like fees and taxes from over-trading. Know your objectives and timeline - concentration builds wealth, while diversification protects it.