The cryptocurrency craze has created enormous demand from retirement account investors who are seeking tax-efficient ways to purchase cryptocurrencies. In addition, some retirement account investors have looked to cryptocurrencies as a way to better diversify their retirement portfolios. Of course, purchasing cryptocurrencies with retirement funds can be decidedly risky due to its volatility and is undoubtedly not for everyone. For those adventurous or daft enough to take on the risk of using retirement funds to purchase cryptocurrencies, here are a few important tips.
Do Your Research. Cryptocurrencies are a relatively new asset class that is quite volatile. There are thousands of crypto coins available for purchase. Hence, it is important to do you research and understand the technology behind each coin or token you purchase. There are plenty of free reliable sites that will provide background information, pricing, market cap, etc. on most of the popular cryptos. However, be mindful of the news source you are reading. It is a good idea to try to surround yourself with people who are familiar with cryptocurrencies and who have investment experience. Also, be cautious of pyramid schemes or multi-level marketing arrangements.
Selecting a Cryptocurrency Exchange. Once you have decided on the types of cryptocurrency you wish to purchase, the next part is deciding what exchange you will use in order to convert your U.S retirement dollars (fiat) into cryptocurrencies. There are a number of popular cryptocurrency exchanges in the United States. However, it is important to do your diligence in selecting the exchange(s) you feel most comfortable with. Most retirement account holders prefer using a United States based exchange, especially after hearing about the $450 million theft that occurred at the Japanese exchange, Coincheck, in January 2018.
Each cryptocurrency exchange has a different fee model, so it is a good idea to familiarize yourself with their fee schedules before signing. Fees can usually range from as low as nothing up to 2% or so. In addition, it is advisable to be cautious of third-party brokers whose fees/commissions can go as high as 5% for their services. In addition, it is helpful to examine the order book volume of the exchange in order to get a good idea of the type of cryptocurrency trading volume the exchange handles. An exchange with a higher order book is a good way of checking the liquidity of the exchange. Also, it is crucial that you do not open the exchange account in your own name. Several of the more popular cryptocurrency exchanges offer specific business and retirement account options.
Wallet Options. For many beginner cryptocurrency investors, understanding how the cryptocurrency wallet works can be quite confusing. It is imperative that one understands how a cryptocurrency wallet works if considering investing in cryptocurrencies. The following is a simplified way of understanding how a cryptocurrency wallet works. Assume you have a glass safe with a locked lid. Inside the glass safe is a gold coin. Anyone can see the glass safe, which is the public key or address. The gold coin contained in the glass safe is the cryptocurrency address. However, only the key holder can actually open the glass safe and get the coin. The key to the glass safe is the private key. It’s like your ATM card pin number or keys to your home. Cryptocurrency users can have multiple wallets, each wallet can hold multiple addresses, and each address holds a balance of cryptocurrency.
When investing in cryptocurrencies, it is imperative that one controls the wallet private key. A wallet is essentially a digital computer file that contains information used in sending and receiving units of a virtual currency. You can hold your retirement account owned cryptocurrencies at an exchange wallet, such as Coinbase, or you can hold your own digital (hot) or hard (cold) wallet. After the events that occurred with Coincheck in Japan, using a digital or hard wallet is considered more secure.
When using retirement funds to purchase cryptocurrencies, it is advisable to use a retirement account plan, such as a self-directed IRA LLC or Solo 401(k) plan, if eligible, that will allow you, as the retirement account holder. to have control over the cryptocurrency wallet. In addition, both types of plans will allow you, as the retirement account holder, the ability to buy and sell cryptocurrencies at your convenience directly through an exchange without having to go through an IRA custodian or third-party broker.
No Self-Dealing. When it comes to using retirement funds to invest in cryptocurrencies, one must be cautious of the IRS prohibited transaction rules outlined in Internal Revenue Code Section 4975(c). In general, with respect to cryptocurrency investments, one cannot buy, sell, or exchange cryptocurrencies with any disqualified person. 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. Thus, so long as you do not buy, sell, or exchange cryptocurrencies with a lineal descendant or an entity associated with a disqualified person, the IRS prohibited transaction rules should not be an issue. In addition, one should be mindful of not holding cryptocurrencies owned by a retirement account in the same wallet with personally owned (non-retirement funds) cryptocurrencies.
Mining Cryptos and Hidden Taxes. In general, all gains associated with the sale or exchange of cryptocurrencies will be tax-exempt if done through a retirement account. However, if you will be using your retirement funds to invest in a passthrough entity, such as an LLC, that does mining activities, any income generated over $1000 could be subject to a tax called unrelated business taxable income (UBTI or UBIT). Under the IRS tax rules, any income generated by a retirement account from a business operated through a passthrough entity could be subject to the UBTI tax rules. Because the IRS treats cryptocurrency mining activities as a business, as per IRS Notice 2014-21, income generated from cryptocurrency mining activities could be subject to the UBTI tax rules. The maximum UBTI tax rate is close to 40%. Hence, anyone considering using retirement funds to invest in a cryptocurrency mining business should be mindful of these rules.