Many Can Benefit From Roth IRAs, Not Just the Mega-Rich

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To defer or not to defer taxes is usually the question when investors choose between the traditional and Roth versions of an individual retirement account. But with recent reports that some of the uber-rich have used Roth IRAs as a tax shelter for phenomenal asset gains, more people are considering whether Roth IRAs might be right for them as well. 

Key Takeaways

  • Mega-rich people reportedly have been using Roth IRAs to shield asset gains from taxes, but financial planners say everyday people can do the same, if on a smaller scale.
  • Because Roth IRA contributions are made with after-tax money, withdrawals at retirement are tax-free.
  • Roth IRAs can add diversity to a retirement portfolio to allow more flexibility in managing taxes during retirement.

PayPal co-founder Peter Thiel in 1999 invested $2,000 in the company, a sum that grew over 20 years into $5 billion. The kicker, according to a ProPublica report published in June, is that because the investment was in a Roth IRA, Thiel, 53, will be able to withdraw that investment completely tax-free once he turns 59½.

Thiel was capitalizing on an investment vehicle authorized by Congress in 1997 to let people contribute to retirement savings with after-tax money and grow the money tax-free, which is the opposite of the traditional IRA lawmakers established in 1974. With traditional IRAs, savers usually get an upfront tax deduction for their contributions, and then pay tax on the money when it’s withdrawn during their retirement. Roth IRA contributions, in contrast, do not enjoy a tax deduction upfront, but withdrawals are tax-free starting six months before the investor turns 60.

The ProPublica report put a spotlight on how some of the richest Americans avoid paying taxes using Roth IRAs and intensified the longstanding debate over whether the wealthy pay their fair share of taxes. But it also ignited renewed interest in how everyday savers might employ Roth IRAs to protect their own retirement savings, especially with President Joe Biden looking to raise taxes to help pay for his spending plans. 

Although financial planners say people can find lots of advantages in Roth IRAs, including tax savings at withdrawal time, they warn that Thiel’s spectacular results are unlikely to be replicated by most people.

"The average person is not going to have a place to invest that has that kind of return potential,” said Rob Williams, managing director of financial planning at Charles Schwab.

Thiel reportedly bought 1.7 million PayPal founders shares at a fraction of a penny through a “self-directed” Roth vehicle before the company held an initial public offering. PayPal shares were last trading on the NASDAQ for more than $290.

Caveat Emptor

Self-directed IRAs have the same tax treatment and contribution rules as traditional and Roth IRAs, but let savers invest in “alternative assets” such as real estate, promissory notes, tax lien certificates, and private placement securities like Thiel’s PayPal shares. 

It's “important to note that many people with large Roth IRA balances have them simply because they invested in a low-priced security that ultimately appreciated greatly,” David Peterson, senior vice president and head of wealth planning at Fidelity Investments, wrote in an email. “We would caution investors against being overly concentrated in any particular position as there is also risk the investment would not perform as expected or even go to zero.”

The Securities and Exchange Commission has also warned that alternative assets “may have unique risks that investors should consider. Those risks can include a lack of disclosure and liquidity—as well as the risk of fraud.”

The Benefits of Withdrawal

Even if people are unlikely to garner the type of whopping returns that Thiel enjoyed with his Roth IRA, financial planners say people can still gain similar tax benefits on a smaller scale—especially if they expect tax rates to rise. That could partly be fueling more interest in Roth IRAs these days.

According to Fidelity Investments, Roth IRAs are especially attractive to its younger investors. From Jan. 1 to June 28, the number of new Roth accounts at Fidelity is up 81% from the same period in 2020, with 47% of those opened by Millennials.

Additionally, people can gain flexibility in retirement if they use a Roth IRA as part of a diversified retirement strategy.

“Having money in a traditional 401k and Roth IRA and a brokerage account can give you flexibility when you retire,” said Schwab’s Williams. “You will be able to decide what money to draw from,” which can help manage tax liabilities in retirement. 

For example, after 59½ you could withdraw a large sum from a Roth IRA if you have a one-time expense or other needs without increasing your tax bill. Keep in mind, though, that large withdrawals could mean you miss out on the potential for compounding gains during retirement.

Limitations? Maybe Not

Some people may think income limitations on a Roth IRA preclude them from being able to invest. Generally, though, a single person with taxable income of less than $139,000 or a married person filing jointly with income of less than $206,000—or a married person filing separately but who lived with the spouse sometime during the year with income below $10,000—can contribute to a Roth IRA. That compares to no income limit to contribute to traditional IRAs, which do have a limit on how much can be tax deductible. Typically, annual contributions for both traditional and Roth IRAs are capped at either $6,000 ($7,000 if you are age 50 or older) or the amount of your taxable compensation, whichever is lower.

But financial planners say those rules should not dissuade you, because there are ways around them. People can use a “backdoor Roth IRA,” or a conversion, which lets people regardless of income level convert all or part of their existing traditional IRA funds to a Roth IRA. The conversion will trigger income tax on the appreciation of the traditional IRA from the day of your contribution, but once those taxes are paid, the Roth IRA will grow tax free. 

Fidelity Investments said it has seen multiyear growth in conversions. From 2018 to 2019, the number of conversions went up by 22%. From 2019 to 2020, conversions rose 67%. 

Once you commit to converting to a Roth IRA, however, there is no going back, because you can’t undo a Roth conversion.

Have a question, comment, or story to share? You can reach Medora at medoralee@thebalance.com.