In 2019, Peter Thiel’s Roth IRA was worth $5 billion. Every investor wants to replicate his strategy, but they don’t understand the details of how he did it.
This post will show you how he did it and why it's nearly impossible to replicate without a unique set of circumstances.
The Timeline of Thiel's Roth IRA
In 1999, Peter Thiel used his Roth IRA to buy 1,700,000 PayPal shares for $1,700, or $0.001/share.
In 2002, eBay bought PayPal in a deal valued at $1.5 billion, making Thiel’s $1,700 investment worth ~$55 million.
Since the shares were owned in his Roth IRA, the entire gain was tax-free. Thiel was 35 at the time, so any withdrawals from the Roth would be subject to ordinary income tax and a 10% penalty.
In 2004, Thiel became the first outside investor in Facebook, buying 10.2% of the company for $500,000, once again using funds in his Roth IRA.
Over the following 10+ years, Thiel made various investments and tax-free sales of Facebook stock to grow the balance to ~$5 billion by the end of 2019.
How Thiel Bought PayPal Shares
Thiel used a Self-Directed Roth IRA (SDIRA).
SDIRAs are similar to conventional IRAs in a lot of ways. They’re offered in Traditional and Roth structures, and they’re subject to the typical IRA contribution, taxation, and withdrawal rules.
What’s different about them and why do entrepreneurs like Thiel and other affluent investors use them?
SDIRAs give account owners broad control and the ability to invest in private stock, real estate, cryptocurrency, and other alternative assets. Conventional IRAs don’t offer this amount of control or investment flexibility.
However, very few people have the circumstances to justify the complexity, fees, and rules associated with managing a SDIRA, and even fewer people can own shares of their business in one.
Complying with Self-Directed IRA Rules
To make a legitimate private investment in your IRA, you must avoid what the IRS calls a prohibited transaction.
To summarize, prohibited transactions prevent your IRA from transacting with you, most of your family members, and in certain scenarios, the business’ shareholders, key employees, and entity itself.
The rules are much more nuanced, so let’s cover the specifics, starting with a list of prohibited transactions directly from the tax code:
You're probably wondering who or what a disqualified person is.
The legal definition is broad, but these are the most common disqualified person(s) you might encounter:
The IRA owner (you) and their spouse
The IRA owner’s parents and grandparents
The IRA owner’s children, grandchildren, and their spouses
Any entity where 50% or more of the company is owned by the people listed in 1-3 (alone or combined)
Officers, directors, owners with an interest ≥10%, and employees who receive ≥10% of annual wages of a disqualified entity like the one mentioned in bullet 4
Allow me to summarize all of that in English.
It’s extremely rare to find a situation that allows you to buy shares of an existing closely held business in your IRA. Even if you find a way to do it, there’s a high probability the transaction will be audited, so you should seek tax and legal counsel before doing anything.
Starting a New Business in a Self-Directed IRA
It’s possible to do this and avoid the prohibited transaction rules above, but there are numerous other rules you must follow that wouldn’t be feasible for most situations.
Most notably, if your IRA owns more than 50% of a company and you’re in charge of making employment and compensation decisions for the company, you can’t personally receive compensation from the business. This would apply to many early businesses.
What can go Wrong?
If you engage in a prohibited transaction, the IRS will consider your entire IRA balance to be distributed as of January 1st in the year the transaction took place.
That means any gain in the Roth IRA (or the whole balance in a Traditional pre-tax IRA) will be taxed as ordinary income. There will also be a 10% penalty if the transaction occurs before you reach age 59 1/2.
Conclusion
While the Peter Thiel story is fascinating, very few people find themselves in a situation to invest in an early stage company that gets acquired for more than a billion dollars. Even fewer people can follow it up with a more lucrative investment like Facebook.
Thiel had the perfect set of circumstances, a one in a million liquidity event, and my guess is he had a team of legal and financial professionals keeping meticulous records to ensure they abided by every rule.
Entrepreneurs and investors should take all this into account before trying to replicate it themselves.
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