What To Know Before Purchasing Cryptocurrencies With Retirement Funds
December 22nd, 2017
Here’s another piece, written by Adam Bergman, that originally appeared on Forbes.com –
With the value of Bitcoins and many other cryptocurrencies flying high in 2017, many investors have looked to take advantage of this trend and own cryptocurrencies in tax-advantaged retirement plans, such as a Self-Directed IRA or Solo 401(k) Plan. This article will explore the main points an investor should know before using retirement funds to buy cryptocurrencies.
What is a Cryptocurrency?
Cryptocurrency refers to a decentralized digital currency that employs principles of cryptography (communication that is secure from view of third parties) to ensure security, privacy, and anonymity. Consequently, the value of a cryptocurrency is not set by anyone other than market participants, who engage in the process of buying and selling on an exchange platform.
Bitcoin has become the leader in shepherding in a wave of cryptocurrencies built on decentralized peer-to-peer network and is the primary standard for cryptocurrencies. The currencies inspired by Bitcoin are collectively called Altcoins and have tried to present themselves as modified or improved versions of Bitcoin. The five most popular cryptocurrencies are Bitcoins, Ethereum (ETH) & Ethereum Classic, Litecoin, ZCash and Dash. There are close to 1000 types of cryptocurrencies, so this list can vary over time.
How does the IRS Treat Cryptocurrencies from a Tax Standpoint?
Even though Bitcoin is labeled as a “cryptocurrency”, from a Federal income tax standpoint, Bitcoins and other cryptocurrency are not considered a “currency.” On March 25, 2014, the IRS issued Notice 2014-21, which for the first time set forth the IRS position on the taxation of virtual currencies, such as Bitcoins. According to the IRS Notice, “Virtual currency is treated as property for U.S. federal tax purposes.” The Notice further stated, “General tax principles that apply to property transactions apply to transactions using virtual currency.” In other words, the IRS is treating the income or gains from the sale of a virtual currency, such as Bitcoins, as a capital asset, such as stocks or real estate, subject to either short-term (ordinary income tax rates) or long-term capital gains tax rates, if the asset is held greater than twelve months (15% or 20% tax rates based on income). By treating Bitcoins and other virtual currencies as property (capital asset) and not currency, the IRS is requiring the investor to maintain detailed transaction records (i.e. basis, holding period, etc.) in order to determine the amount of tax from the cryptocurrency transaction(s).
Can I purchase Cryptocurrencies with a Retirement Account?
The Internal Revenue Code does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain types of transactions. The foundation of the prohibited transaction rules is based on the premise that investments involving an IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the IRA and certain individuals known as “disqualified persons.” The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
Because the IRS treats cryptocurrencies, such as Bitcoins, as a capital asset, such as stocks or real estate, a retirement account is permitted to buy, sell, or hold cryptocurrencies, subject to the prohibited transaction rules found under Internal Revenue Code Section 4975(c).
Why use a Retirement Account to Invest in Cryptocurrencies?
When purchasing cryptocurrencies, such as Bitcoins, with a Self-Directed IRA, all income and gains generated by your pre-tax retirement account investment would generally flow back into the retirement account tax-deferred or tax-free in the case of a Roth IRA. Instead of paying tax on the gains of the crypto investment, tax is paid only at a later date or never at all, in the case of a Roth IRA, leaving the crypto investment to grow unhindered without tax.
How to Use Retirement Funds to Buy, Hold, or Sell Cryptocurrencies?
In general, the two most popular ways to purchase cryptocurrencies with retirement funds is through a Self-Directed IRA. Below is a step-by-step summary of how to purchase cryptocurrencies with a Self-Directed IRA:
Because of the volatility involved in purchasing cryptocurrencies, most Self-Directed IRA custodians will require you to establish an LLC to hold the cryptos. The IRA would be the owner of the LLC and the LLC would be the vehicle used to purchase the cryptos.
- Establish a Self-Directed IRA account with an IRA custodian.
- Rollover retirement funds, cash or in-kind, tax-free to new Self-Directed IRA account.
- The IRA assets will then be transferred to the LLC tax-free in exchange for 100% interest in the newly established IRA LLC.
- You, as manager of the LLC, will open a bank account for the LLC at any local bank.
- You, as manager of the LLC, will then have “Checkbook Control” over all the assets/funds in the IRA LLC to make the cryptocurrency investment.
- A cryptocurrency account would be opened in the name of the IRA LLC.
- You, as manager of the LLC, will then wire the IRA LLC funds to the new cryptocurrency account opened at a crypto exchange. The account will be opened in the name of the IRA LLC.
- The cryptos can then be held at the exchange or via an online or offline wallet.
- Since the LLC is owned 100% by an IRA, it will be treated as a disregarded entity for tax purposes. No Federal income tax return is required to be filed, although, some states may impose filing or franchise taxes on the LLC. Accordingly, in general, all income and gains from the cryptocurrency investment should flow back to the IRA without tax. One should consult with their tax advisor to better understand the implications of using a special purpose LLC wholly owned by an IRA to purchase cryptocurrencies.
Cryptocurrency investments, such as Bitcoins, are risky and highly volatile. Any retirement account investor interested in using retirement funds to invest in cryptocurrencies should do their diligence and proceed with caution.