A popular vehicle among investors who wish to allocate to alternatives, a self-directed IRA is a tax-advantaged retirement account that lets you choose and manage your investments. It’s structured like a standard IRA—with the same contribution limits, distribution rules, and tax advantages—but with greater flexibility, options, and control.
In 2005, renowned venture capital firm Accel Partners invested $12.7 million in Facebook. At the time, Facebook was a year-old social network for college students headed by then-21-year-old Harvard dropout Mark Zuckerberg. When Facebook went public seven years later on May 18th, 2012, Accel’s 200 million share position had grown to roughly $10 billion in value. The firm’s whopping 787-fold return shattered records and became what was then the most profitable investment ever in venture capital history.
While scoring a Facebook-like exit that “returns the fund” is not the median outcome among venture capital firms or venture-backed startups, investing in alternative assets may be—even on average—more profitable than holding publicly-traded stocks and bonds.
Tax-conscious investors who intend to hold long-term positions can even invest in venture capital using a self-directed individual retirement account (IRA).
A popular vehicle among investors who wish to allocate to alternatives, a self-directed IRA is a tax-advantaged retirement account that lets you choose and manage your investments. It’s structured like a standard IRA—with the same contribution limits, distribution rules, and tax advantages—but with greater flexibility, options, and control.
Specifically, a self-directed IRA allows you to expand beyond publicly traded asset classes and into alternatives like venture capital, private credit, Pre-IPO stocks, real estate, art, cryptocurrency, and more. Gaining access to a broader universe of investment opportunities means that you can more granularly tailor your portfolio to match your risk tolerance, goals, and market outlook.
What Is Venture Capital and Why Use a Self-Directed IRA to Invest?
Venture capital is a form of private equity financing in which individual or institutional investors provide funds to early-stage, high-growth companies in exchange for an equity or ownership stake. These nascent startups then leverage their financiers’ capital and expertise to fuel future growth and expansion. If a venture-backed company is successful, it may experience a liquidity event like an acquisition, Initial Public Offering (IPO), or merger. At this point, venture capital investors will typically exit their investments by selling their stakes in the company.
Of course, investing in venture capital is not a get-rich-quick scheme. The average time horizon from initial investment to liquidity event—if one occurs at all—is roughly seven to ten years. This long-term orientation is reminiscent of the patience that investors must cultivate when saving for retirement—one of many factors that may make venture capital a suitable asset class to pursue within a self-directed IRA.
Higher Returns
Historically, venture capital investments have outperformed stocks and bonds. While publicly traded equities and bonds delivered an average annual return of 10% and 5% over the past decade, respectively, venture capital managed to notch annual returns of 12%.
Put another way, $10,000 invested in stocks at the beginning of the decade would have grown to about $25,937; for bonds, that same figure would have grown to $16,289. Invest your money in venture capital, however, and you would be left with $31,058—or $5,121 more than if you had invested in publicly traded stocks.
Long-Term Growth
As mentioned previously, venture capital investments do not become liquid until their underlying venture-backed startups achieve maturity. This means that funds often come with extensive lock-up periods that can span the lion’s share of a decade or more.
Although illiquid investments are poor options if you need money in a pinch—the on-demand mark-to-market liquidity of exchange-traded securities would arguably be a better fit for you there—long lock-up periods happily work in harmony with the goals of self-directed IRAs.
After all, self-directed IRAs impose early withdrawal penalties against investors who withdraw their funds before the age of 59 ½. By putting your money in venture capital, you commit your funds for an extended time. This gives your investments a chance to mature and may help serve as a natural deterrent against excessive trading—a practice that is shown to lower long-term returns.
Portfolio Diversification
Beyond offering higher returns than exchange-traded stocks or bonds, the asset class boasts uncorrelated returns as well. This is important because investors often do not—and arguably should not—commit to a single asset class. Rather, investing in several uncorrelated asset classes at once enables you to harness the benefits of diversification.
Specifically, diversifying across asset classes means that you can reduce portfolio volatility and improve risk-adjusted returns—the amount of profit achieved per unit of risk assumed.
Market Opportunities
Startup valuations—which have fallen precipitously from the zenith notched in Q4 2021—are now beginning to trough.
Notably, while the median pre-money valuation of seed-stage deals dropped nearly 17% in the second quarter of 2023, recent data from private market data vendor Pitchbook show that multiples have remained stagnant in the third quarter of this year. This signals that a near- or long-term bottom may be near—a forecast that, if accurate, may present an attractive and affordable entry point for new entrants to the asset class.
Tax Advantages of Holding Venture Capital Returns in a Self-Directed IRA
Like standard IRAs, self-directed IRAs come in two varieties: traditional and Roth. Both offer significant tax advantages, though the timing of the benefits will differ.
With a traditional self-directed IRA, you make pre-tax contributions and thus receive an upfront tax deduction.
On the other hand, Roth self-directed IRAs involve after-tax contributions. Though you receive no upfront tax deduction, any returns generated within the account are permanently tax-exempt. Crucially, this means you’ll enjoy entirely tax-free withdrawals in retirement.
Due to the tax-advantaged nature of both traditional and Roth self-directed IRAs, tax drag—the negative impact of income taxes on a portfolio’s returns—is reduced or eliminated. This enables long-term investors like yourself to compound your wealth at a much faster pace than if you were to make the same investments outside a tax-advantaged retirement account.
A prime example of this is Peter Thiel, the co-founder of PayPal. In 1999, Thiel contributed $2,000 to a Roth IRA—the only contribution he ever made to the account—to purchase shares of PayPal, then a newly-incorporated startup, for $0.001 each.
When eBay bought PayPal for $1.5 billion in 2002, Thiel’s $2,000 stake ballooned into $28.5 million. Subsequent investments—including a $500,000 investment in Facebook in exchange for 10.2% of the company in August 2004—enabled Thiel to grow his Roth IRA’s value to over $800 million by 2008.
By 2021, his Roth IRA had ballooned to over $5 billion—the largest in existence today. If Theil had invested taxable funds, he would have faced a roughly $2 billion capital gains tax bill. However, if he waits until he turns 59 ½, which will happen in 2027, he may not have to pay a single cent in taxes upon withdrawal.
How to Set up a Self-Directed IRA for Venture Capital
To turn a standard IRA into a self-directed IRA, you’ll need to find a custodian company that is experienced with self-directed IRAs and comfortable with alternative investments like venture capital. While your custodian will not provide financial advice or manage your assets, they’ll hold your investments securely and ensure compliance with government and IRS regulations.
Next, you’ll need to fund your self-directed IRA account. You may do so either by transferring existing IRA or 401(k) funds or by making contributions directly. The 2023 annual contribution limit is $6,500, or $7,500 for those aged 50 or older. The limits will increase to $7,000 and $8,000, respectively, in 2024.
Once your self-directed IRA is funded, you can research various venture capital funds and startups that align with your investment goals and risk tolerance. Conduct due diligence by analyzing offering memorandums, track records, and team expertise. Understand the fund’s investment focus, the individuals making the investments, and their expected distribution timeline.
Finally, open an account directly with the venture capital firm through your self-directed IRA custodian. Keep a close eye on your investments and stay updated on the portfolio companies’ progress.
Considerations: Risk Tolerance, Fees, and Regulatory Compliance
Venture capital investments are not for the faint of heart. Startups are inherently risky, and up to 90% of young companies fail within five years of formation. Even successful ventures—those that experience significant liquidity events—may take years to yield returns. Before investing, you should carefully evaluate your risk tolerance and ensure that your portfolio can withstand the risks associated with this asset class.
Understanding the fees associated with self-directed IRAs and venture capital investments is likewise important. For instance, you may incur custodian fees, along with fund management fees and carried interest fees that may be charged by your venture capital fund. You should be comfortable with the fee structure and its impact on your potential returns.
Also, while self-directed IRAs expand your investment choice set, there are still some limits to consider. In particular, you can’t hold certain assets like collectibles, life insurance, or S corporation stock, nor can you invest in a company that you’re involved in running.
Engaging in other prohibited transactions—such as borrowing money from the account, selling personal property to the account, or using the account as collateral for a loan—can also lead to unexpected taxes. Consider consulting a financial advisor or tax consultant to steer clear of penalties and fraud.
At The Spaventa Group, we’re eager to help forward-thinking investors like yourself tap into venture capital—whether through taxable funds or a self-directed IRA.
Our alternative funds invest in early-stage and private companies in evolving sectors such as space, mixed reality, fintech, food tech, artificial intelligence, robotics, and life sciences.
