The cryptocurrency Bitcoin wowed investors in 2017 by soaring from an initial price of about $1,000 to new records of nearly twenty times as much. Another virtual coin called “Ethereum” began the year trading at around $7 and climbed to almost 100 times that level.
Naturally enough, many investors are wondering whether and how these digital assets can be incorporated into their own retirement portfolios. In fact, it is possible to add Bitcoin, Ethereum, and other digital currencies to the sorts of IRS-sanctioned Individual Retirement Account (IRA) so many investors rely upon.
Just What Are Bitcoin and Ethereum?
Bitcoin and Ethereum are both distributed digital currencies, although the details vary significantly. In general, a distributed currency is one where transactions are recorded on digitized ledgers maintained on a worldwide network of participating computers.
Most digital currencies rely on a cryptographically protected computer file known as a “wallet” as proof of ownership. Bitcoin and Ethereum both fit this mold but differ in a number of other important ways:
- Bitcoin is the original cryptographic currency and still by far the most widely traded. It came online in 2009 when a still-pseudonymous programmer released the enabling software to the world. Since then, Bitcoin has gone through some dramatic ups and downs, although the overall trend has been markedly upward. Bitcoin is by far the most liquid of all cryptocurrencies and has also achieved the highest level of mainstream adoption. From the Cboe futures that became available on December 10, 2017, to funds like the Grayscale trust, Bitcoin’s prominence and history have helped make it the virtual currency of choice for many established financial players.
- Ethereum is a significantly newer alternative to Bitcoin that also includes some novel features. Rather than being only a cryptographic currency in its own right, Ethereum includes a software system that allows for the creation of binding digital contracts. Ethereum can be thought of as a platform for the launch and hosting of other currencies and projects that run upon its distributed virtual machine. At the same time, Ethereum can also be traded directly, much as Bitcoin is, with the value associated with subsidiary tokens influencing the price of the parent currency.
Does the IRS Allow Cryptocurrencies in IRAs?
Yes. The IRS does not approve particular types of investments to be held in IRAs, rather only prohibiting designated “collectibles” and life insurance. Cryptocurrencies like Bitcoin and Ethereum are considered “personal property” under IRS tax rules, as clarified in the agency’s Notice 2014-21.
At the same time, the IRS does not deem virtual currency to be a “collectible” form of property, so that no general prohibition against adding them to IRAs exists. While it is entirely possible to invest in Bitcoin or Ethereum through an IRA account, all the usual precautions must be observed. Issues ranging from improperly set up accounts to prohibited types of transfers could cause the IRS to deem an investment ineligible at a later date, with otherwise avoidable tax obligations ensuing.
How to Buy Bitcoin or Ethereum with an IRA
There are two basic ways to set up a retirement account that can be used to invest in Bitcoin or Ethereum:
- A so-called “captive” IRA opened with a suitable provider will allow an investor to buy into one or both cryptocurrencies using whichever forms of access the custodian enables. This style of virtual currency retirement investing is most similar to the standard IRA options with which the average investor is already familiar. The advantage of this approach is that there will be relatively little to do to get the account set up and fewer possible mistakes to make along the way. At the same time, a captive cryptocurrency IRA will not necessarily provide an investor with the direct (but custodian-mediated) ownership of Bitcoin or Ethereum that many seek.
- The self-directed IRA is the other major option. Just like with IRAs that are used to invest in real estate or other alternative asset classes, self-directed accounts that are meant for holding Bitcoin or Ethereum require quite a bit more care regarding setup and management than captive ones. When properly utilized, however, this style of IRA can hold Bitcoin or Ethereum directly.
What It’s Like to Set Up a Self-Directed Bitcoin or Ethereum IRA
Investors who choose to open a captive, cryptocurrency-specific IRA should find the process to be much like establishing a conventional account. With self-directed IRAs, things necessarily become more complicated. Each custodian or IRA provider will have its own process in place, but one or both of the following additional details will typically crop up:
- Wallet. Because a self-directed IRA will hold Bitcoin or Ethereum directly, instead of through some indirect means provided by a custodian, a wallet must be created and somehow associated with the account. One important requirement is that this must not be an existing, personal Bitcoin or Ethereum wallet, as this would delegitimize the arrangement in the eyes of the IRS. Some custodians will have clients create new wallets using established, third-party services whose independence reduces liability concerns while improving privacy for IRA beneficiaries.
- Checkbook control LLC. Another common option is for a custodian to equip every client with a limited liability company (LLC) freshly created to own the cryptocurrency wallet and be responsible for all the associated transactions. This seemingly more complicated arrangement has been used successfully with self-directed IRAs of other kinds for many years. An investor who opens an IRA of this type, however, must always be sure to assign responsibility to the LLC wherever relevant, lest the arrangement otherwise end up being deemed invalid by the IRS.
In either case–and with captive-style IRAs, as well–investors will be allowed to make all the usual choices regarding this style of retirement investing. Whether that means rolling over a balance from an existing IRA or 401(k) into the new account or starting fresh with an annual contribution, the usual funding options will be available.
Likewise are Bitcoin- and Ethereum-eligible accounts of both basic kinds available in all the well-known IRA forms, from traditional and Roth styles to SEP plans for small business owners. Working with a custodian with a well established, thoughtfully designed process will ensure that all these important questions can be answered successfully and appropriately.
References and Further Reading