The ultra-rich have exploited Roth IRAs. You are able to do the identical

Sometimes it can seem like only rich people can benefit from the tax code.

Some ultra-rich individuals have amassed hundreds of millions – or even billions – of dollars in tax-protected Roth pension accounts, according to a report released Thursday by ProPublica, an investigative news agency. However, the strategy is basically available to anyone who wants to use it.

“The great thing about Roth is that it’s the best tax haven for everyone,” said Ed Slott, Chartered Accountant and Founder of Ed Slott and Company.

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With traditional 401 (k) plans and IRAs, you generally get a tax break if you make contributions and then pay tax on the retirement payouts. In contrast, Roth versions of these accounts come with no upfront tax break, but qualified withdrawals are exempt from federal income tax.

While there are income limits on who can contribute directly to a Roth, higher-income investors can convert assets in a traditional IRA or 401 (k) – whose retirement payments are taxed as normal income – into a Roth.

The converted money is taxed, but can then grow tax-free and be withdrawn completely tax-free as long as you have been in the account for at least five years and are 59½ years or older.

Billionaires who have exploited the Roth IRA rules include Peter Thiel, one of the founders of PayPal, whose account was valued at $ 5 billion, according to ProPublica’s 2019 report, after being valued at under $ 2,000 in Year 1999. (CNBC did not independently review any details in the report.)

A self-directed Roth IRA

Jason York | Getty Images

Thiel apparently used a self-directed Roth IRA to protect his investments. This type of account offers the same tax benefits as a standard Roth account – tax-free growth and untaxed distributions – but also allows you to invest in assets that are not available on regular Roth accounts.

For example, a self-administered Roth IRA can hold investments such as real estate or private company shares, which, according to ProPublica, Thiel first held in his account in 1999 before PayPal was a publicly traded company.

Self-directed IRAs are usually only available through specialist custodians – not big financial firms like Fidelity Investments or Vanguard, which offer a wide range of investments like listed stocks, bonds, mutual funds, and the like.

The great thing about Roth is that it’s everyone’s best tax haven.

Ed Castle

Founder of Ed Slott and Company

In contrast, custodians who hold self-managed IRAs have nothing to do with the investments you put in your account.

“They won’t be monitoring you,” Slott said. “They’re not going to advise you on tax laws – it’s up to you. You have to know what you’re doing.”

There are also valuation problems, he said. While you can know the value of publicly traded securities, some alternative assets are more difficult to evaluate and it is up to you to get it right so you don’t clash with tax laws.

Once the assets are in the account, however, you can at some point – presumably at a profit – sell them and use the proceeds to buy other assets in the account, all under the Roth tax-free umbrella.

Even if a self-directed Roth IRA doesn’t suit you, you still get the tax benefits of investing through a standard Roth IRA.

“Anything you think has high growth potential should go to a Roth,” said Slott.

Roth accounts can also help avoid the uncertainty about where tax rates will be in retirement, Slott said.

If your money is in a traditional IRA or 401 (k), which means it will be taxed when it is paid out, the rate you end up paying may be higher than today’s tax rate. In addition, Roth accounts do not have minimum payouts required – amounts that must be paid annually once you reach the age of 72 – for the lifetime of the original account holder.

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