IRAs and other tax-favored retirement accountsare a must-have tool to help you retire on your own terms. With a smart investment strategy, you can use IRAs to defer or even entirely avoid thousands of dollars in taxes over your lifetime.
But the success of some investors in boosting their IRAs to amazing heights has drawn attention lately, both from those seeking to emulate their methods and from others searching for possible foul play. These methods may not be available to average investors, but the lessons they teach could help you in your own quest to retire rich.
Obviously, the key to making your IRA grow is to find investments with the most potential for capital appreciation. Hedge funds and private equity investments give high-net-worth investors access to high-risk, high-reward investments that many ordinary investors can't get into. But as a recent Wall Street Journal article explains, Bain Capital -- the private-equity firm where presidential candidate Mitt Romney worked -- used some interesting financial engineering to create exactly the sort of investments that could soar in a tax-favored account.
As the Journal explains it, the strategy involved dual classes of stock. One class was relatively safe and offered reasonable but not outsize returns. The other involved a substantial risk of total loss, but to compensate, it was also entitled to much larger rewards if the investment went well. So when deals like the one Bain made to turn around Sealy (NYS: ZZ) resulted in big gains, Romney and his fellow Bain employees were able to multiply their IRA balances over the years -- because they put those high-reward shares in tax-favored accounts.
Bain may have been uncommon in its use of this strategy, but others have used the same basic principle. Last year, I noted how PayPal co-founder and early Yelp (NYS: YELP) investor Max Levchin leveraged his IRA into a $128 million stake in the newly public social-media company.
If you want to get the same results from your IRA, you have to be willing to take some big risks. The Levchin route would involve making an investment in a small, private company and hoping that it will eventually take off and go public. That's great if you have a nose for good investments, but plenty of venture capitalists end up losing everything they put into a single venture.
Shouldyou get in?
Ironically, it might actually be easier to go the Romney route. Ordinary investors don't have access to dual classes of shares, but they do have the ability to use high-risk, high-reward investment vehicles like options and leveraged ETFs. Even in retirement accounts, where options use is restricted, you can still buy call or put options to make bullish or bearish bets on a wide range of stocks or ETFs.
The problem is that using options this way is like playing the lottery. What it takes to win is a stock that continuously defies the investing world by beating expectations repeatedly, pushing shares upward quickly over short time periods. So as Apple (NAS: AAPL) has consistently posted huge sales numbers for its latest devices, many call-option owners have seen even bigger rewards than ordinary shareholders. As lululemon athletica (NAS: LULU) has evolved from a tiny niche retailer to a giant in a huge and growing market, call options could have earned you huge multibagger gains above and beyond the stock's returns. And as priceline.com (NAS: PCLN) has found a way not just to survive the European sovereign debt crisis but to carry on a thriving business on the Continent while many of its peers were crumbling, options investors were in a great position to profit.
The main difference is that while time was on private equity investors' side, time is against you with options investing. If a stock rises too slowly, options investors can still lose everything -- even if their call turns out to be correct in the long run. Private equity folks, on the other hand, have years to see how things play out.
In order to have any chance of having a strategy like this work, you have to be comfortable with the prospect of losing your entire retirement savings. That's not something that most people are in a position to do. Although young investors may have the wherewithal to lose everything in their modest accounts and then start over, I still think the prudent course is to accept less than Romney-sized returns in exchange for greater certainty that your money will still be there when you need it. That may keep you from being Romney-rich -- but it improves your odds of having a perfectly respectable nest egg waiting for you when you retire.
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At the time thisarticle was published Fool contributor Dan Caplinger has an IRA that's perfectly sized for him -- for the moment. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Apple and lululemon athletica. Motley Fool newsletter services have recommended buying shares of Apple, priceline.com, and lululemon athletica, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy comes in just the right size.
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