Cryptocurrency & Self-Directed IRAs: Benefits and Risks

To expand their portfolio and generate increased profits from their investments, numerous investors are transitioning from standard IRAs (traditional and Roth) to self-directed IRAs (SDIRAs).

The former restricts investment opportunities to conventional assets such as stocks, bonds, real estate, mutual funds, ETFs, and certificates of deposit, whereas the latter enables investment in unconventional assets such as cryptocurrencies, real estate, commodities, and private placement.

As bitcoin, a form of digital currency, has exhibited better performance than stocks – which are conventionally viewed as having the greatest prospects for growth – in recent years, numerous investors are contemplating the addition of cryptocurrency to their self-managed Individual Retirement Accounts (IRAs).

For these investors, a bitcoin IRA presents an ideal chance to expand their portfolio and receive higher profits. However, considering the instability of digital currency, a comprehensive perspective regarding advantages and disadvantages is necessary.

What Are Bitcoin and Cryptocurrency IRAs?

Begin by understanding the nature of cryptocurrencies. They can be defined as electronic currencies that utilize blockchain technology to guarantee decentralization and anonymity.

Cryptocurrencies are not like fiat currencies such as dollars, pounds, and euros, as they are generated by a large number of individuals using various computer networks globally, and the supply is not governed by any central authority.

A blockchain is formed by connecting blocks that contain individual transactions, which are recorded on a distributed ledger in cryptocurrency transactions. Anonymity is maintained through the use of a public key consisting of a set of codes that represents each transaction party. The public availability of transactions enables parties involved, as well as third parties, to verify them.

Bitcoin and Bitcoin IRA

Prior to the creation of bitcoin in 2009, other cryptocurrencies existed but lacked success. The triumph of bitcoin paved the way for the emergence of additional cryptocurrencies. Currently, Coin Market Cap estimates that the worldwide cryptocurrency market is valued at $2.14 trillion.

Bitcoin was initially created as an electronic currency. However, due to its limited availability (there can only be up to 21 million BTC in circulation) and the lack of a central authority to manipulate its supply, many supporters believe it serves as an excellent investment tool. The logic behind this is that if demand rises while supply remains constant, the price will increase.

Thanks to the acceptance of the Electronic Frontier Foundation, Bitcoin experienced a significant surge from $1 on February 9, 2011, to $1,237 in December 2013, confirming the predictions made by its proponents.

From that time on, numerous individuals have earned millions and the value reached its maximum at $68,789 on November 10, 2021.

Since February 2011, the price has increased by 4,738,468% from its initial value of $1. SoFi claims that the price has experienced an annual compounded growth rate of 100-200%.

In contrast, the S&P 500, which tracks the 500 largest American stocks, experienced a growth of only 250% in the same timeframe. At present, bitcoin’s market capitalization stands at $896 billion, surpassed solely by Apple, Microsoft, Amazon, Alphabet, and Tesla.

As a result, a lot of investors are contemplating the incorporation of bitcoin into their self-directed IRA, leading to the emergence of the notion of a “bitcoin IRA.” Essentially, a bitcoin IRA refers to a self-directed IRA that involves the inclusion of bitcoin in its investment portfolio.

What Are the Benefits of Bitcoin and Cryptocurrency IRAs?

Having grasped the fundamentals of bitcoin and cryptocurrency, let’s explore some of the perks that prompt investors to incorporate them into 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.

What Are the Risks of Bitcoin and Cryptocurrency IRAs?

Although bitcoin and cryptocurrencies typically offer advantages, they also come with certain risks, so comprehending these risks is crucial in informing your decision-making process.

Cons of Including Crypto in a Self-Directed IRA

Volatility
- 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, etherium 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.

What Is a Self-Directed Individual Retirement Account (SDIRA)?

A self-managed individual retirement account (SDIRA) is an IRA that is able to accommodate investments that are not typically allowed in regular IRAs, like commodities, precious metals, and real estate. SDIRAs follow the same contribution limits as traditional and Roth IRAs, with a maximum contribution of $6,500 per year and $7,500 for individuals over 50 years old (an increase from $6,000 and $7,000 in 2022).

How Do You Set Up an SDIRA?

Per the Internal Revenue Service (IRS), all retirement assets, including those in SDIRAs, must be held by a qualified custodian. The custodian—which could be a bank, credit union, or other financial institution—administers the SDIRA, holds the account’s investments for safekeeping, and ensures that the SDIRA complies with IRS rules.

Although you can establish an IRA or SDIRA at almost any financial institution or bank, larger custodians typically do not provide access to non-traditional investments like precious metals, real estate, or cryptocurrencies. Consequently, it is crucial to locate an SDIRA custodian who grants access to the desired non-conventional assets. Additionally, it is important to note that these firms are not authorized to offer investment recommendations, so it is your duty to perform investment research.

How to Open an SDIRA

To open a self-directed IRA (SDIRA), you will need to look beyond the usual options of stocks, bonds, and mutual funds or ETFs that are available for investment in a regular IRA (traditional or Roth) with most IRA providers.

Find a qualified IRA custodian that specializes in SDIRAs.
Determine whether they offer the range of investments you want.
Set up the account and pay any fees.
Begin contributing to your account.

It is important to note that SDIRAs are self-directed, which means that financial advice cannot be provided by custodians. As a result, it is uncommon for traditional brokerages, banks, and investment firms to provide them to their clients. Therefore, it is crucial to conduct extensive research. In case you require assistance with selecting or monitoring your investments, seeking the help of a financial advisor is recommended.

Traditional vs. Roth SDIRA

It is possible to establish traditional or Roth IRAs as self-directed accounts, but it is important to remember that each type of account is subject to varying tax treatments, eligibility criteria, contribution regulations, and distribution guidelines.

A key difference between a traditional and a Roth IRA is when you pay the taxes. With traditional IRAs, you get an up-front tax break, but you pay taxes on your contributions and earnings as you withdraw them during retirement. When you contribute to a Roth IRA, you don’t get a tax break, but your contributions and earnings grow tax-free, and qualified distributions are also tax-free.

Naturally, there are additional distinctions that require contemplation. Here’s a brief summary:

Income limits: Traditional IRAs have no income limits, but you must make less than a certain amount to open or contribute to a Roth.8
Required minimum distributions (RMDs): You must start taking RMDs at age 73 if you have a traditional IRA.6 Roth IRAs have no RMDs during your lifetime.9
Early withdrawals: With Roth IRAs, you can withdraw your contributions (but not your earnings) at any time, for any reason, with no tax or penalty. Withdrawals are tax and penalty-free after age 59½, provided the account is at least five years old. With traditional IRAs, withdrawals are penalty free starting at age 59½. Remember, you have to pay taxes on traditional IRA withdrawals.710

The rules remain consistent across all types of SDIRAs.

Investing in an SDIRA

A vast array of investment possibilities becomes available when investing in a self-directed Roth IRA. Along with the common investment options such as stocks, bonds, and mutual funds, non-traditional retirement portfolio assets can also be acquired.

In your SDIRA account, there are various investment options available, such as investment real estate, partnerships, tax liens, and even franchise businesses.

SDIRAs, both the traditional and Roth versions, have limitations on certain investments according to the Internal Revenue Service (IRS). Prohibited investments include life insurance, S corporation stocks, any investments that constitute self-dealing prohibited transactions, and collectibles.

A variety of items fall under the category of collectibles, including but not limited to antiques, artwork, alcoholic beverages, baseball cards, memorabilia, jewelry, stamps, and rare coins. This distinction determines the type of gold that can be held in a self-directed Roth IRA.

Who Offers SDIRAs?

An SDIRA can be established at almost any bank or financial establishment that permits them. However, if you desire to invest in unique assets like real estate and precious metals, you have to locate a company that is skilled in handling alternative investments. Prior to opening an account, be sure to conduct thorough research and consult a financial advisor to confirm if an SDIRA suits your financial goals.