Technology has fundamentally changed how individual investors can get access to IRAs. In recent years, the rise in popularity of cryptocurrencies has also changed the type of investments available to investors. Cryptocurrencies emerged in popularity after the Great Recession as an alternative to the traditional banking system. Younger investors are more likely to express an interest in bitcoin. As a result, there has also been a growing interest among some investors to own digital currency such a bitcoins and other cryptocurrencies in their IRAs.
What Is a Bitcoin IRA?
While you may see many references to Bitcoin IRAs, there is no specific IRS-backed account specifically designed for cryptocurrencies. However, individual retirement accounts (IRAs) are a potential vehicle to hold bitcoin and other alternatives to bitcoins known as "altcoins". The Internal Revenue Service (IRS) released a statement in 2014 announcing they would treat bitcoin the same way they view stocks and bonds for taxation purposes. The IRS decided to consider cryptocurrencies as a property, and as a result, this designation requires a custodian in order to comply with regulations.
Owning bitcoins in an IRA typically involves special planning because most IRA custodians only accept more mainstream assets such as stocks, bonds, mutual funds, REITS, money market funds, and certificates of deposits (CDs). This is where self-directed IRAs come into the picture. Self-directed IRAs (SD-IRA) offering non-traditional investments have steadily increased in popularity in recent years. Self-directed IRAs have been used to invest in real estate, precious metals, notes, tax lien certificates, and private placements. More recently, self-directed IRAs have been used to hold cryptocurrencies. These self-directed IRAs allow you to buy and hold bitcoins or buy shares of dedicated funds that hold these assets.
Owning Bitcoin and Other Virtual Currency in Self-Directed IRAs
Changed to Bitcoin was the first digital cryptocurrency created and remains one of the most widely recognized. But Bitcoin has its fair share of company and, as of April 2021, more than ten thousand other cryptocurrencies or altcoins have come into existence since Bitcoin was first introduced. Based on market value, Ethereum, Maker, and Litecoin are some of the largest alternative forms of cryptocurrency. A few examples of exchanges that specialize in matching buyers and sellers of digital currencies in the U.S. include Genesis, Coinbase, and Kraken.
It is not likely that you will see cryptocurrencies available in retirement plans at work anytime soon. Retirement plan sponsors are liable for the type of investments they offer and cryptocurrencies are currently too volatile. While some government agencies around the world are preparing for these digital assets, they currently are not regulated. Cryptos are also not widely viewed as a separate asset class. Many financial professionals are more optimistic about the long-term prospects of blockchain technology—the underlying technology behind them—than they are about cryptos themselves.
Simply having access to investment does not necessarily mean holding it in an IRA is for everyone. In fact, stocks, bonds, and cash are the most common asset classes used to save for retirement. Here are some of the pros and cons of holding bitcoins and other digital cryptocurrency assets in a self-directed IRA.
Potential Benefits of Owning Cryptocurrencies Within a Self-Directed IRA
The easiest way to own bitcoin and other virtual currencies is to hold them as regular taxable investments. As such, buying and selling decisions are subject to capital gains taxes. By focusing on some good old fashioned tax-diversification or "asset location," you can reduce the tax implications of buy and sell transactions. This is because self-directed IRAs give retirement savers the ability to invest in cryptocurrencies in a tax-deferred account. They do so by pairing self-directed IRAs with a cryptocurrency wallet that operates as a special account for virtual currencies. This can help reduce overall taxes.
Choosing between a Roth and traditional IRA comes down to whether you prefer paying taxes now or later. While there is tremendous uncertainty about the long-term prospects of cryptos, Bitcoin IRAs can provide significant upside potential. The possibility of large gains is what attracts many to place speculative investments in bitcoin and altcoins. The tax-free growth of earnings in a Roth IRA can be enticing for investors seeking to minimize taxes from those potential gains.
The Downside Risks of Bitcoin IRAs
Bitcoin and other digital cryptocurrencies are extremely volatile and are primarily viewed as a speculative investment. They differ from stocks in that they do not represent ownership in a corporation that has underlying valuation metrics such as price-to-earnings and price-to-book ratios. Cryptos do not generate earnings or dividends and are all based on prices which fluctuate significantly on a day-to-day basis. With so many cryptocurrency investments to choose from, it is impossible to predict which ones will be around for the long-term. Going forward, one way to reduce some of the risks would be to find a low-cost, exchange-traded fund that holds a basket of cryptocurrencies.
Self-directed IRAs can be more costly than IRAs offered through traditional brokerage firms. The additional custodial fees can be cost-prohibitive for smaller investors. If you are considering using a self-directed IRA custodian to hold virtual currency, be sure to do your homework on the overall costs associated with buying and selling cryptos.
A diversified mix of asset classes such as stocks, bonds, and cash remains the most advisable core holdings of a retirement portfolio. There are other financial planning milestones that should be met prior to considering using a self-directed IRA to invest in bitcoin. For example, financial priorities include establishing an emergency fund, eliminating high-interest debt (i.e., credit cards, private student loans), and contributing enough to a retirement plan to capture an employer match.
Many financial advisors suggest avoiding cryptocurrencies due to expectations of a looming crypto crash, while others predict significant future growth. Only time will tell. In the meantime, it is important to maintain a diversified retirement portfolio. For those investors interested in this speculative alternative investment, some general guidelines are to maintain an overall allocation in alternatives that don’t exceed 5 to 10 percent of the overall portfolio.