📈 Investing your retirement funds in private markets

If you have money saved in a retirement account – like 401k, 403b, IRA, or Roth IRA – your investment options may be restricted to things like stocks, bonds, and mutual funds.

But according to ProPublica, wealthy Americans have been using their retirement accounts to invest in private market investments to create a tax advantaged fortune!

The most notable example is the founder of PayPal – and now billionaire venture capitalist – Peter Thiel.

According to the same ProPublica article, Thiel started a Roth IRA in 1999 with assets that at the time were worth less than $2,000. Those assets are now valued at $5 billion.

That’s why in 2014, the U.S. Government Accountability Office (GAO) released its report regarding the prevalence of so-called “Mega-IRA” accounts.

The GAO report, which used 2011 tax data, showed nearly 8,000 taxpayers had aggregate IRA account balances of $5 million or more.

Since then, that number has ballooned by more than threefold.

According to data requested from the Joint Committee on Taxation (JCT), as of the 2019 tax year, more than 28,000 taxpayers had aggregate IRA account balances of $5 million or more, and 497 taxpayers have aggregate IRA account balances of $25 million or more.

Even crazier? The average aggregate account balance for these 497 taxpayers was more than $150 million.

How did they turn this retirement savings program, designed for everyday Americans, into a tax shelter for the super-rich?

And more importantly, how can you use the same legal strategies used by Insiders and Elites to potentially boost the value of your retirement accounts?

That’s the topic of today’s issue of Private Capital Insider.

(Spoiler: they use their retirement funds to invest in private market opportunities that you are not allowed to invest in by using a “normal” IRA or 401k)

-Jake Hoffberg

P.S. Recently, we’ve had several readers express interest in using their retirement accounts to invest in private investment offerings listed on Equifund.

• [Disclaimer: Investing in private investments may involve a high degree of risk, including the potential loss of some, or all, of the principal invested. If you are considering allocating a portion of your retirement assets to these investments, you may want to discuss it with your personal financial advisor.]

Chances are, your current IRA custodian – especially if held with larger firms like Fidelity, Vanguard, T. Rowe Price, TD Ameritrade, or Charles Schwab – does not allow you to own private securities (or if they do, it may be subject to a lengthy approval process)

This means you will need to open something called a Self-Directed IRA (SDIRA), transfer funds into that SDIRA, create an account on Equifund using that SDIRA, and then make an investment from that account.

For a comprehensive guide on SDIRAs, please refer to our article here.

While we don’t endorse any SDIRA custodian in particular, some of our members use low-cost providers like AltoIRA and IRA Financial.

P.P.S. If you are interested in using your retirement funds to invest in Nevada Canyon Gold – which is currently a publicly traded company – please confirm with your SDIRA custodian that you are permitted to hold publicly traded securities in addition to securities issued under Regulation A+.

If not, you will likely incur additional administrative burdens when attempting to deposit shares into a brokerage.

P.P.P.S. This will likely be Part 1 in an ongoing series I like to call “Secret Investment Strategies of Insiders and Elites,” where we talk about how tax-advantaged vehicles – like 401(k)s, IRAs, corporate entities, trusts, health savings accounts, and life insurance policies – can be used to build generational wealth.

In the same vein as our recent article on taxes, in mathematical terms, the best way to improve returns is to reduce fee drag.

Generally speaking, taxes are the single largest expense we pay every year. However, reducing your lifetime tax burden usually requires forward-looking planning to properly build the entities and structures required to reduce taxes like Insiders and Elites do.

While we cannot provide any individualized advice or recommendations about what you should do in regard to your specific situation, I fully expect people to have a LOT of questions about how these things work.

Feel free to hit reply with any questions you do have, so I can address the topic in future issues.

A Brief History of Retirement in America: The Shift from Pension Plans to IRAs and 401ks

On Labor Day, September 2, 1974, President Gerald Ford signed into law a landmark legislation called the Employee Retirement Income Security Act (ERISA). 

Prior to ERISA, employee pensions had few protections under the law. This, not surprisingly, provided opportunities for employers to “cheat” employees out of their earned retirement benefits.

With the passing of ERISA, the federal government’s role in regulating private-sector retirement plans was greatly expanded.

Not only did it make the government the guarantor of private pensions, by creating the Pension Benefit Guaranty Corporation (PBGC)...

It also increased the safety of the establishment, operation, and administration of private retirement plans, by delegating regulatory oversight to three federal agencies, which was a unique approach at the time.

• The Department of Labor, through the Employee Benefits Security Administration (“EBSA,” formerly known as the Pension and Welfare Benefits Administration) was given primary responsibility for promoting rules for reporting and disclosure. It also became responsible for determining the duties imposed on fiduciaries, who by law, are required to act in the best interests of the employees.
  

• The Internal Revenue Service (IRS) was given primary responsibility for participation, funding, and vesting rules.
  

• The PBGC was given the task of providing insurance to protect benefit promises made by sponsors of Defined Benefit plans (aka “pensions”).

ERISA covers two types of retirement plans: Defined Benefit (DB) plans and Defined Contribution (DC) plans.

• DB plans provide eligible employees with guaranteed income for life when they retire. Employers guarantee a specific retirement benefit amount for each participant, based on factors such as the employee’s salary and years of service.

Under a DB plan, employees have little control over their funds until they are received in retirement. The company takes responsibility for the investment and for its distribution to the retired employee.

That means the employer bears the risk that returns on the investment will not cover the defined-benefit amount due to a retired employee.

• A DC plan does not promise a specific amount of benefit at retirement. The employee will ultimately receive the balance in their account – which is determined based on contributions and the performance of the investments in the participant’s individual account, minus any fees and taxes.
  
  Examples of DC plans include 401(k) plans, 403(b) plans, employee stock ownership plans, profit-sharing plans, SIMPLE IRA, and SEP-IRA.

In passing ERISA, Congress intended to harmonize the regulation of all tax-advantaged retirement plans, including IRAs, to prevent, among other things, “[u]njustifiable differences in [the] tax treatment of corporate owner-employees and self-employed individuals under qualified plans.”

At the time, while DB plans were the dominant type of employer-sponsored retirement plan, Congress placed various limits on both DB and DC plans.

For DB plans, benefits are limited to amounts needed to provide an annual benefit no larger than the lesser of a specific dollar amount, or 100% of the participant’s average compensation, for the highest of three consecutive calendar years.

While DB plans have a limit on total benefits, DC plans (like IRAs) have no limits on how much the account can accumulate. Instead, DC plans have annual contributions limited to the lesser of a specific dollar amount or 100% of the participant’s compensation.

More importantly, while DB plans are managed by the company, individuals have control over how they invest assets in DC plans.

However, as investors sought more diverse investment opportunities, the need for Self-Directed IRAs arose.

While traditional IRAs limited investments to publicly traded securities like stocks, bonds, and mutual funds…

Funds cannot be used to invest in what is commonly called “alternative assets” – like real estate, private equity, precious metals, art, tax liens, farmland, water rights, hard money lending, and cryptocurrency.

According to Kirk Chisholm of Innovative Advisory Group, a firm specializing in self-directed retirement accounts for the wealthy:

However, DB plan managers have been investing in alternative assets as early as the 1970s – and gained significant momentum in the 1980s, as leveraged buyouts became popular – seeking market-beating options to meet their long-term obligations.

That all changed thanks to The Taxpayer Relief Act of 1997; its primary purpose was to provide tax incentives for saving and investing for retirement.

While the act didn't explicitly create SDIRAs, it introduced key provisions that facilitated their development, and expanded investment options within retirement accounts.

Most notably, the introduction of the Roth IRA – a new type of retirement account that allows individuals to make after-tax contributions. While contributions to Roth IRAs are not tax deductible, qualified distributions are tax-free.

This new account type laid the foundation for the concept of self-directed IRAs, by allowing individuals to invest in a broader range of assets.

In addition, Roth IRAs allow the withdrawal of principal (i.e., the money you put in) at any time, with no penalty, subject to a few exceptions.

Back to Self-Directed IRAs…

With the birth of the IRA in 1974, various IRS rules were codified to help govern how IRA funds could be invested.

The Internal Revenue Code did not state what investments were permitted, only which investments were not. In short, life insurance, collectibles, and various transactions were deemed prohibited when involving a “disqualified person.”

The issue was that it was next to impossible to make alternative investments; an IRA was required to be opened at a bank, financial institution, or regulated trust company.

The companies that fit that description tended to work mostly with stock market products. Hence, an IRA that was being held by these companies was automatically slotted into their investment model (i.e., products they can get commission and fees on).

This really only started changing in the 1980s when independent companies began to apply for non-bank trustee status.

This allowed them to hold IRA accounts but within a framework that would permit alternative assets.

But the most significant innovation in SDIRAs was the invention of what is called a Self-Directed IRA LLC or “Checkbook IRA.”

The idea of "checkbook control" emerged as investors recognized that they could have more direct access to their retirement funds by using an LLC structure.

This allowed them to write checks or make electronic transactions directly from the LLC's bank account, rather than going through a custodian for every investment.

The Swanson v. Commissioner case in 1996 affirmed the legality of using an LLC owned by an IRA to hold real estate investments. This case provided further clarity on the IRS's position regarding self-directed IRAs, and paved the way for the use of the LLC structure for alternative investments.

Three Strategies for Building Your Mega IRA

To come back to the point of this article – how do individuals wind up with a $5m+ Mega IRA – let’s first take a look at the math behind building a $1m - $5m retirement account.

As a caveat, here is what the GAO report says about these assumptions:

In addition to this aggressive assumption of fully maxed-out contributions, also according to the GAO:

So how do you wind up with more than $5m, if even the hypothetical model requires 30 years of contributions and above-market returns?

Answer: a little bit of “legalized cheating” that is normally reserved for Insiders and Elites – non publicly traded shares (i.e., private investments) and partnership interests.

Why? In order to generate ridiculously outsized returns, the key is to buy at a ridiculously low price.

Even among this select group, only a small number of individuals can use non publicly traded shares and partnership interests to generate a large IRA.

For example, only the founders of companies – and some of their initial employees and investors – have access to non-publicly traded shares issued at the creation of the company, at which time these shares can be valued at less than $0.01 apiece.

This is exactly what Peter Thiel did to turn a $1,700 investment in PayPal into what eventually became a $5bn tax-free Roth IRA fortune.

Thiel allegedly paid $0.001 per share – called “Par Value” – of PayPal, and bought 1.7 million shares for a total investment of $1,700.

Three years later, in 2002, when eBay acquired PayPal for $1.5 billion, Thiel sold his 1.7 million shares, earning a whopping $55.5 million… of which he then invested $500,000 into Facebook, later turning that into roughly $1bn in tax-free returns.

But what if you’re not the founder of a massively successful startup?

Don’t worry, you can still get access to these shares if you happen to work at a private equity fund.

According to the GAO report,

Even better, if you happen to have access to the carried interest (or “carry”) in the private equity fund, you can make even more money.

Here’s how this one works…

The general partner typically distributes a portion of this fee to a few key employees, by first granting them a profits interest in the fund.

Even better, profits interests in a private equity fund or hedge fund can be valued as low as $0.00, because they do not necessarily represent a cash investment to the fund on the part of key employees.

Instead, they represent an agreement that key employees will provide expertise, ideas, and work to make the fund a success, in exchange for a share of the fund’s profits, and are treated as a nontaxable event when granted.

But what if you don’t work at a private equity fund and have no access to profit interests?

Your third and final option is to invest in private offerings on alternative investment platforms like Equifund.

While you may not be able to acquire “cheap shares” or profit interests in your account, you may have the opportunity to invest early in potentially promising companies that might deliver above-market returns.

Final Thoughts: Should you use your retirement funds to invest in high-risk investments?

Have you ever heard the classic parental question, "If your friends jump off a bridge, would you?"

Well, let me ask you this: Just because wealthy individuals are using Roth IRAs to amass tax-free gains from high-risk, high-reward stock plays, does that mean you should follow suit?

Maybe. But maybe not.

Like all things in investing, it’s important you understand the risks you’re taking and plan accordingly.

While billionaires might have the luxury of offsetting these losses through other transactions, the same can't be said for the average person.

Even though there is an attractive upside of tax-free gains in a Roth IRA, you lose the opportunity to take a tax deduction on any losses – which you would have if you purchased the investment in a taxable account.

Another issue is the administrative costs involved with setting up an SDIRA, along with any additional fees like:

• Account opening fees

• Account closing fees

• Administrative fees

• Custodian fees

• Asset value fees

• Transaction fees

• Outbound Wire Fees

• Inbound Wire Fees

Remember, SDIRA custodians are for-profit businesses, not charities.

If you don’t understand how they make money, your retirement savings could get eaten alive by the fees… especially if you have a smaller-sized account!

Please be sure to talk to your financial advisor regarding your personal situation, who can help you understand what options are right for you.