As a way to diversify and earn higher returns on their investments, many investors are switching from regular IRAs (traditional and Roth) to self-directed IRAs (SDIRAs).
While the former limits investment to traditional assets like stocks, bonds, real estate, mutual funds, ETFs and certificates of deposit, the latter allows investment in non-traditional assets like cryptocurrencies, real estate, commodities and private placement.
Given how bitcoin, a type of cryptocurrency, has outperformed stocks — the traditional asset with the highest potential for growth — over the years, many investors are now considering including cryptocurrency in their self-directed IRAs.
To these investors, a bitcoin IRA is a perfect opportunity for diversification and better returns. Nevertheless, given the volatility of cryptocurrency, we must take a holistic view that includes benefits and risks.
What Are Bitcoin and Cryptocurrency IRAs?
To start, consider what cryptocurrencies are as a whole. Simply put, they are digital currencies that are operated through blockchain technology to ensure that they are decentralized and anonymous.
Unlike fiat currencies like dollars, pounds, and euros, cryptocurrencies are mined, or created, by many people operating multiple computer systems all over the world. There is no central government controlling the supply.
Cryptocurrency transactions are recorded on a distributed ledger, and each transaction forms part of a block which is connected to other blocks — hence, a blockchain. Each party to a transaction is represented by a public key, a series of codes, maintaining their anonymity. Since transactions are publicly available, they can be verified by the parties involved and others.
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Bitcoin and Bitcoin IRA
Though there were some cryptocurrencies before bitcoin, they were unsuccessful. The success of bitcoin, created in 2009, paved the way for other cryptocurrencies. Now, the global cryptocurrency market is worth $2.14 trillion according to Coin Market Cap.
While bitcoin started as a digital currency, its limited supply (there cannot be more than 21 million BTC in circulation) and the absence of a central authority to increase or decrease supply at will led many enthusiasts to consider it as a good store of value: if demand increases while supply is stable, price will rise.
Bitcoin proved its enthusiasts right, rising from $1 on February 9, 2011 to $1,237 in December 2013 due to adoption by the Electronic Frontier Foundation as a means of payment.
Since then, many have made millions from it, and the price peaked at $68,789 on November 10, 2021.
From that $1 price in February 2011, it has grown by 4,738,468%. According to SoFi, the price has compounded by 100-200% every year.
For comparison, the S&P 500, an index of the 500 largest US stocks, only grew by 250% during the same period. Today, bitcoin has a market cap of $896 billion. Only Apple, Microsoft, Amazon, Alphabet and Tesla have higher market caps.
Consequently, many investors are now considering including bitcoin as part of their self-directed IRA, hence the “bitcoin IRA” concept. A bitcoin IRA is simply a self-directed IRA that includes bitcoin as one of its investments.
What Are the Benefits of Bitcoin and Cryptocurrency IRAs?
Now that we understand the basics of bitcoin and cryptocurrency, let’s consider some of the benefits that make investors include them in their SDIRA.
Pros of Including Crypto in a Self-Directed IRA
- Potentially Higher Returns
As history has proven, bitcoin and other cryptocurrencies can rise significantly enough to produce out-of-this-world returns for investors. Even though bitcoin was a bit more stable in 2021 than in previous years, Visual Capitalist reported that it still produced 59.8% returns compared to the 26.9% returned by the S&P 500.
Consequently, risk-seeking investors can benefit from potentially higher returns compared to traditional investments.
- More Diversified Portfolio
Since data from Morningstar had shown that bitcoin has an almost zero correlation to the stock market, many have dubbed it the “digital gold.” Investors have traditionally relied on gold to diversify their portfolio of stocks and bonds due to its near-zero correlation to both markets. Now, bitcoin has shown the same characteristic between 2012 and 2020, leading many to view it as a diversification tool.
It bears stating that recent data is making this case for bitcoin as the digital gold less solid. Nevertheless, investors continue to use bitcoin as a diversification tool. Since other cryptos are new, there has not been significant research on their diversification potentials.
- Future Potential
On September 7, 2021, El Salvador set a milestone when it accepted bitcoin as a legal tender. Many crypto enthusiasts believe that a wider acceptance of crypto as means of exchange is imminent. If this belief becomes reality, then the future potential of crypto is enormous. Consequently, many investors who don’t want to miss out on such potential are considering including cryptocurrencies in their IRAs.
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What Are the Risks of Bitcoin and Cryptocurrency IRAs?
Despite its benefits, bitcoin and cryptocurrencies generally have some risks. Understanding those risks is vital to your decision-making process.
Cons of Including Crypto in a Self-Directed IRA
While the prices of cryptos can move up significantly, they can also go down significantly in little time.
Bitcoin reached $1,237.55 on December 4, 2013 and then slumped to $697.02 in just three days, a 44% loss. Similarly, it was at $12,913.28 on June 26, 2019 before falling to $6,635.84 on December 17, 2019. The same has been proven with the other cryptocurrencies. For example, Ethereum fell by 40% between mid-November 2021 and January 2022.
- Hype and Scams
Over the years we have seen many cryptos rise and fall. These cryptos are called dead coins. Coinopsy, a website that keeps a list of these coins, defines dead coins as “cryptocurrencies that have been abandoned, used as scam, their website is down, has no nodes, has wallet issues, doesn’t have social updates, has low volume or developers have walked away from the project.”
Not surprisingly, there are 2,398 entries on the website. Between 800-1000 ICOs (initial coin offerings) failed by 2018 according to a report by The Quartz Index.
At the crypto scam level, Time reported that an estimated $14 billion were lost to crypto scammers in 2021 alone. This is especially worrying for cryptocurrency and bitcoin IRAs since custodians of self-directed IRAs have no obligation to conduct due diligence on behalf of their clients. If you choose cryptocurrencies, you are solely responsible for protecting yourself from dead coins and other forms of scams.
- High Fees
Self-directed IRAs are generally expensive, and you can expect to incur an initial setup fee, maintenance fees and custodial fees, among others. Since purchasing cryptocurrencies can be very expensive on its own, these fees can quickly become significant.
- Finding a Custodian
Not all IRA providers offer self-directed accounts. In addition to the stress of finding a general SDIRA custodian, you must also find one that will allow you to buy cryptocurrencies. The list is smaller and negotiation for better fees may become difficult.
- Prohibited Transactions
Any transaction you make on your bitcoin IRA or cryptocurrency IRA must not be made to benefit you personally, your descendants or any business you have at least a 50% stake in.
The IRS has full details on prohibited transactions to understand before making any investments.
How To Include Bitcoin in a Self-Directed IRA
Now that you know the benefits and the risks, the ball is in your court. If you decide to take the plunge, there are steps to take to add crypto to your self-directed IRA portfolio.
- Find a Custodian
- Every IRA must have a custodian, and cryptocurrency IRAs are not exempt. The aim here is to find a custodian that allows you to purchase cryptocurrencies and then evaluate the available custodians to get the best value for money and best fit for you.
- Create an LLC or Invest Through a Broker
- Once you have found a custodian, you have two broad options for purchasing your cryptocurrencies.
How To Include Crypto in Your SDIRA
First, you can create a limited liability company, or LLC, under your IRA. An IRA with an LLC is called a checkbook IRA. If you follow this route, these are the required steps:
- Open a checking account for your IRA LLC.
- Use your IRA LLC name and tax number to open an account on a crypto exchange.
- Transfer money from the checking account to the exchange.
- Purchase the cryptocurrencies of your choice.
Instead of crypto exchanges where individual cryptos are purchased, you can also choose to register your LLC on platforms that allow you to buy crypto ETFs or trusts.
Alternatively, you can purchase cryptocurrencies through a broker. Here, the broker does all the work for a fee. All you need to do is create orders to be executed.
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How Does the IRS View Cryptocurrency Investments?
According to the IRS, virtual currencies are treated as properties for tax purposes. Gains from their sale are thus treated as capital gains and are subject to short-term or long-term capital gains tax.
If your bitcoin or cryptocurrency IRA is a traditional SDIRA, contributions to it are tax-deductible and distributions are taxed at the point of withdrawal. On the other hand, if your bitcoin or cryptocurrency IRA is a Roth SDIRA, contributions are not tax-deductible, but qualified withdrawals are tax free.
As is clear, investing in crypto as part of a self-directed IRA is not well suited for the everyday investor. Before choosing to open a bitcoin IRA or any other cryptocurrency IRA, ensure you’ve weighed the benefits and risks involved. And, if you choose to go forward, always do due diligence to avoid potentially dead coins and crypto scams.