Have you been watching the price of bitcoin and thought about adding some of the cryptocurrency to your retirement portfolio? Specifically, if you already have an IRA or are about to start one, you might have wondered, “How can I create a self-directed IRA (SDIRA) that holds bitcoin?”
If so, it’s essential to understand the ins and outs of what a SDIRA is, how bitcoin IRAs work, and what the pros and cons are of these type of accounts that hold bitcoin as their primary asset. Cryptocurrencies like bitcoin are a relatively new asset class.
In fact, the IRS classifies them not as money or currency but as property. So, if you’re planning to invest in bitcoin, for retirement or otherwise, it helps to know from the beginning that you’re dealing with a very special form of asset.
Background: The Price of Bitcoin
With no central bank, government, or administrator, bitcoin is truly what it claims to be, namely a digital, fully decentralized currency with no physical form and travels between holders without intermediaries. It debuted on the world stage in 2009, and for the following seven years, it hovered in value well under the $1,000 mark.
As more people became aware of it and started using it for a limited number of financial transactions, its value began to rise in early 2017, reaching almost 20 times its value from the beginning of that year to the $19,000 zone. When that happened, many speculators and people who earned huge profits in a short period drew attention to the alternative coin as a potentially attractive asset.
Within a year, by late 2018, bitcoin’s price had sunk back down but still rested at about three times its original 2017 value. Within six months, by mid-2019, it had reached the psychologically important $10,000 mark, then proceeded to hover between $5,000 and $29,000 until the end of 2020.
When the COVID pandemic hit, millions of people began to view the coin as a form of safe-haven investment, which propelled its price up to $63,000 by mid-2021. Then, once the pandemic was mainly over, the crypto fell back to the $34,000 range. Where will it go between now and 2030? No one can say for sure, but it appears that bitcoin endures a subsequent fall with each new high. However, the falls usually are not as significant as the climbs, which is how it got to its current price level.
What Is a Self-Directed IRA?
Compared to traditional and Roth IRAs, which use either pre-tax or after-tax money and delay the tax burden until the account holder withdraws the funds, a self-directed IRA is both similar and different. As far as the delayed tax feature, that’s the same. But as to what you can put into the IRA, that is the critical difference.
When you open a typical IRA through a bank or broker, you’re generally limited to asset classes like cash, stocks, and select mutual funds. It’s really up to the financial institution to decide what can go into the IRA, whether it’s a Roth or traditional version.
When it comes to SDIRAs, you have much more leeway in terms of choosing assets. For instance, as long as the IRS does not legally restrict an asset, you can hold it in a self-directed retirement account. So, except for life insurance and collectibles, you can decide for yourself what to put into a SDIRA, and the list is a long one. It includes assets like bitcoin, gold, silver, other precious metals, stocks, bonds, exchange-traded funds, options, futures, investment-grade real estate, and more.
In order to set up a SDIRA, you need to find a custodian who will secure the assets, manage the account, and make sure you follow IRS guidelines concerning investing and reporting. Fortunately, many custodians will agree to help you create a bitcoin SDIRA.
How Do Bitcoin SDIRAs Work?
Not every IRA custodian works with self-directed IRAs or with bitcoin. You need to find a competent custodian who regularly accepts bitcoin as an asset placed into a SDIRA. Because self-directed accounts are set up in the same way as other SDIRAs, you won’t have to do any additional paperwork to create one after locating a licensed custodian.
After filling out the initial couple of pages of paperwork, signing the forms, and providing ID (a driver’s license will do), you’ll need to purchase bitcoin to put into the account. That’s where your custodian comes in. They can buy the cryptocurrency for you and fund the account with it. There’s also a question of storage. The better custodians use offline “cold wallets,” which are the safest way to keep bitcoin and other cryptos from being hacked, stolen, or otherwise tampered with.
There are two kinds of SDIRAs, ones with active custodians and those with passive custodians. Active custodians oversee the account, secure the funds, provide you with statements, and perform other services. Passive custodians basically set up your IRA as an LLC and give you complete “check-book” control over the account. That way, you can deposit money or bitcoin into it anytime you want, without going through the custodian.
What is valid for all other forms of assets is true for bitcoin: pros and cons are associated with owning it. Among the core advantages are the ability to diversify a retirement portfolio. Additionally, investors often view bitcoin as a hedge against inflation and the genuine threat of a financial and economic crisis.
The COVID pandemic of 2020 was one such crisis, during which the value of bitcoin performed admirably. Another plus for bitcoin is its historical tendency to rise in value over time, even though it does so in a roller-coaster fashion. Examine the price changes listed above, and it’s easy to conclude that as more people use the coin and as it becomes better known among investors, there’s a possibility that its value could rise to levels far beyond what has already occurred.
Just looking at 2020, even though it was a crisis year in many ways due to the COVID virus, bitcoin delivered higher returns than both the S&P 500 and the most beloved “safe haven” investment of all, gold. That’s just one year, but it demonstrates the growing acceptance of bitcoin as both an asset and a form of currency.
What’s the downside of bitcoin? For risk-averse investors, bitcoin might not be a good fit. Even though it’s been around for 12 years and is the cryptocurrency with the largest capitalization rate, its day-to-day price swings can be pretty significant. Like so many other “new” assets, it appears that the global market is still sizing up bitcoin to see whether it will be a long-term form of value.
There are tax considerations related to bitcoin that are unique. For starters, the IRS classifies it as property, which means when you withdraw it from an IRA, you’ll be paying long-term capital gains taxes on the distributions, not personal income tax rates. That’s actually a hard fact to assess because both personal and capital gains tax rates fluctuate from time to time.
For investors who don’t like to pay fees for account services, an IRA is perhaps not the ideal place to park retirement money. That’s because, due to the unique nature of cryptocurrency, there are fees associated with keeping it secure in an account, acquiring it, and performing all the custodial chores. For this reason alone, it is essential to ask lots of questions of the custodian you select, particularly about fee schedules, security measures, and what you pay to purchase bitcoin for your account.
Final Thoughts: Key Considerations
If you want to set up a self-directed bitcoin IRA, you need to do a few preliminary tasks, but they’re no more time-consuming or challenging than setting up a traditional IRA.
✔ First, it’s essential to know what bitcoin is and how its price has behaved since coming into existence in 2009. If the cryptocurrency will be the main asset in your new IRA, learning about it is part of any investor’s due diligence.
✔ Next, understand the way a bitcoin SDIRA works. Taking the time to select and speak with a licensed custodian is the best way to accomplish this. It’s also an effective way to find a custodian that can meet your needs in customer service and experience.
✔ Finally, after deciding how much money you’ll be putting into a bitcoin self-directed IRA, always be aware of the pros and cons of using cryptocurrency as a form of retirement investment. Understanding both the positive and negative aspects of bitcoin will help guide you and instill a sense of discipline in your attitude toward expected returns. Bitcoin is a volatile asset, but it can act as an excellent form of diversification for people who want to both protect and enhance their retirement savings.