It turns out, however, that there are some very potent tax planning devices easily and legally available to Americans. They’re called Individual Retirement Accounts, or IRAs.
IRAs come in two basic flavors. The first, the conventional IRA, is an account that you fund with pre-tax money. You take an income tax deduction when you put money into it, meaning that money escapes tax for the time being. That money stays in the account and grows, assuming it’s invested wisely. The tax needs to be paid whenever that money comes out of the account. It can come out when you are quite a bit older, perhaps when you are retired and aren’t making tons of other money so the tax bite won’t be bad as it would have been if you paid the tax on it when you earned the money back in the days when you were working.
For most people, there is a limit of $6,000, varying by year, that can go into an IRA of either flavor. But there are exceptions. If you are self-employed, for example, the annual limit can be quite a bit higher.
The second flavor is the Roth IRA. This account is funded with money you already have paid tax on. But it gives you tax-free growth and tax-free distributions for the rest of your years. And then, when you die, your heirs get to live off a Roth IRA’s tax-free money for up to ten years. Again, there are annual limits on how much you can throw into this kind of account.
Finally, if you have a conventional IRA but you really want the benefits of a Roth, it’s possible to convert. The price, however, is that tax needs to be paid on the money that goes from the conventional to the Roth IRA, the same as if the money simply had come out of the conventional IRA as a distribution. If you are in a situation where your business has operating losses and the losses are just sitting on your income tax return gathering dust (which is not a terribly uncommon situation given the COVID-19 pandemic and the related lockdowns and restrictions in 2020) then converting your conventional IRA to Roth might simply result in absorbing the losses and not payment of lots more tax. The interesting thing is that there isn’t a limit on conversion, as long as the tax gets paid.
Perhaps the most extreme example is tech investor Peter Thiel. According to an article from ProPublica, Thiel parlayed a modest investment in a Roth IRA by having the IRA buy some shares in startup companies, one of which was PayPal. PayPal exploded in value, some of the PayPal shares were sold to invest in other startup companies, like Facebook Inc., and the cycle continued. That Roth IRA is now worth $5 billion. Not a penny of tax will be charged when the money comes out, as long as he doesn’t touch the account until he is aged 59-1/2.
Sure, he was one lucky (or brilliant, or both) fellow to be able to pick the winners successfully. But the point is that IRAs are available to ordinary people as well, and can yield decent tax benefits for ordinary people as well.
Tax is an extremely complicated beast, but it does have occasional features that can help many of us. It’s up to us to learn what they are and use them for our own advantage if appropriate.