You may have heard about people investing in Bitcoin and other digital currencies with their retirement account.
It sounds strange. But it is possible.
You can purchase cryptocurrency through a self-directed IRA, which is a tax-advantaged retirement account used to hold alternative investments, such as real estate, commodities, and yes, even cryptocurrency.
But why hold such a volatile asset like Bitcoin in a retirement account?
The short answer: Tax breaks.
Owning digital assets like crypto inside this type of IRA helps shield traders from paying taxes on investment transactions made within the account. If you sell an investment inside an IRA, you won’t owe taxes until you withdraw the money.
In contrast, transactions made on cryptocurrency exchanges or broker platforms like Robinhood are subject to short-term and long-term capital gains tax — whether you withdraw the money or not.
But self-directed IRAs aren’t right for the average investor — or even the average crypto investor.
Even if you believe in the long-term growth potential of Bitcoin or other virtual currencies, self-directed IRAs are complex and come with high fees.
Read on to learn how these accounts work to see if a self-directed IRA is right for you.
What Is a Self-Directed IRA?
A self-directed IRA is a unique individual retirement account that lets you put your money in alternative assets.
Examples of alternative assets include:
Gold, silver and other precious metals.
Real estate properties. (Note: There’s a slew of additional rules you must follow to invest in real estate with a self-directed IRA.)
Startups and shares of privately-held companies.
Tax lien certificates and deeds on foreclosed properties.
Undeveloped or raw land.
LLC membership interest.
Self-directed IRAs are intended for experienced investors. People use these accounts to chase higher returns and diversify their retirement funds outside of traditional assets.
Self-Directed IRAs vs. Other IRAs
Self-directed IRAs aren’t like any other retirement account you’ve heard about.
Unlike other retirement accounts, self-directed IRAs:
Let you invest in alternative investments normally prohibited in 401(k)s and other IRAs.
Are complex and difficult to set up.
Charge high fees.
Don’t generally permit traditional assets, like stocks, bonds or mutual funds.
Have complicated record-keeping and tax-reporting requirements.
Are only offered by certain banks and trust companies.
Here are some similarities between self-directed IRAs and other IRAs:
You can choose between traditional and Roth accounts and benefit from tax advantages.
Annual contribution limits are the same: $6,000, or $7,000 if you’re 50 or older in 2021 and 2022.
You can roll over funds from a regular IRA or 401(k) to a self-directed IRA.
Self-Directed IRAs Require a Special Custodian
You’ll likely have a hard time opening a self-directed IRA.
Brokerage firms typically act as custodians for IRAs, but most big-name brokers like Vanguard and TD Ameritrade do not offer self-directed IRAs.
Instead, custodians of these accounts are often banks or trust companies that specialize in self-directed IRAs.
Examples of companies that offer custodians for self-directed IRAs include Millennium Trust Company, Pacific Premier Trust, Equity Trust, Madison Trust and IRA Financial.
To make things more complicated, you usually can’t buy non-traditional assets directly from a self-directed custodian. Instead, you must purchase them from another broker. Your IRA custodian only holds these assets after you’ve purchased them.
Each custodian determines which investments it will accept. Some custodians specialize in specific assets, like silver or Bitcoin, while others are more general.
To be clear: Some financial institutions — like Fidelity, Charles Schwab and Merrill Edge — claim to offer self-directed IRAs. In reality, these are self-managed IRAs that let you pick the traditional assets inside your account.
You can open many IRAs for free without paying account management or trading fees.
That’s not the case with self-directed IRAs.
From set-up fees to trading and account management fees, self-directed IRAs aren’t cheap to open or maintain.
On average, you can expect to pay between $250 and $395 to set up a new self-directed IRA, although costs vary from custodian to custodian.
Before you open one of these accounts, it’s essential to understand the costs and fees involved.
Many custodians charge a one-time establishment fee, a first-year annual fee, an annual renewal fee and quarterly custodian fees.
These costs can quickly add up, cutting into your IRA funds and earnings.
Tax breaks are a big reason investors choose self-directed IRAs.
When you set up one of these accounts, you can opt for a traditional or Roth version.
With a traditional IRA, you can usually take a tax deduction on any contributions you make to the account. Growth within the account is tax-deferred. When you withdraw money later, distributions are taxed as ordinary income.
With a Roth IRA, contributions don’t qualify for tax deductions. However, you get to enjoy tax-free withdrawals when you take money from your account down the road.
Here are other differences between a Roth and traditional IRA:
Income limits: There are no income limits for traditional IRAs, but you must earn less than a certain amount to open or contribute to a Roth IRA.
Required minimum distributions: You’re required to start taking RMDs at age 72 if you have a traditional IRA. Roth IRAs have no RMDs during your lifetime.
Early withdrawals: Roth IRAs let you withdraw your contributions (but not your earnings) at any time without paying taxes or a penalty. With traditional IRAs, you will owe a 10% IRS tax penalty on withdrawals made before age 59.5 and you always pay income tax on withdrawals.
Self-directed IRAs typically aren’t set up to accommodate traditional assets like stocks and bonds. So you’ll need to maintain a separate IRA or 401(k) to carry out your more traditional retirement investing goals.
Because self-directed IRAs are so complex, you should find a financial advisor with experience managing investment deals for these types of accounts to help you with due diligence. Custodians aren’t allowed to provide financial advice.
How Do You Buy Bitcoin With a Self-Directed IRA?
A Bitcoin IRA is a marketing term coined by custodian companies to describe self-directed IRAs specifically structured to hold cryptocurrency investments. Bitcoin IRA is also the name of a company that specializes in these types of retirement accounts.
More online platforms are offering Bitcoin IRA services, including iTrustCapital, Coin IRA and BitIRA.
The company Bitcoin IRA said it’s processed more than $1.5 billion worth of transactions for more than 100,000 users since 2016, according to Bloomberg News.
These IRAs make it easier, and somewhat more secure, for small-time investors to create a self-directed IRA and add virtual currency to their retirement portfolio.
However, nearly all of these platforms still charge high fees like other self-directed custodians.
These specialized Bitcoin IRAs are complex. However, custodian companies like the ones mentioned above take care of most of the paperwork.
How Bitcoin IRAs Work
The most common way to get crypto investments into a self-directed IRA is through a process known as an IRA LLC with checkbook control.
After opening your account, a limited liability company is created, which the IRA owns. You can then pick your digital assets through the crypto exchange of your choice.
Here’s how it works.
After opening a self-directed IRA with a custodian, you transfer money or initiate a rollover to fund your account.
Next, a single-member LLC is formed and registered in the name of the IRA.
The LLC then opens a business checking account using money from the IRA. This is referred to as a checkbook IRA. Funds in the checking account are only used to purchase cryptocurrency assets.
An account must then be created on a cryptocurrency exchange in the name and tax number of the IRA LLC. (Making transfers from a crypto exchange account in your own name versus the IRA’s name can result in IRS penalties.)
From there, the self-directed IRA LLC manager (you) can make investments from the LLC checking account.
Some IRA custodians have simplified the process for investors. For example, IRA Financial Group has integrated with Gemini, a leading cryptocurrency exchange. The new integration lets investors buy and sell digital currency in a self-directed IRA without the need of an LLC or third-party broker-firm.
3 Reasons Why You May Not Want to Buy Crypto in a Self-Directed IRA
Self-directed IRAs aren’t user-friendly. They’re complex, not widely available and expensive.
They simply don’t make sense for the average investor.
Here are three other reasons to think twice about using retirement savings to invest in cryptocurrency.
You take on all the responsibility: The IRA tax benefit disappears if you don’t follow IRS rules exactly. As the account holder, you could face serious penalties and owe interest if you accidentally break a tax rule.
Crypto regulations are constantly changing: You can buy crypto in a self-directed IRA now — but that could change in the future. Cryptocurrency is currently considered property for federal tax purposes. But if the IRS decides to classify crypto as a different asset type, you could be forced to liquidate at an unfavorable time or face severe tax issues.
Creating an LLC is expensive: A self-directed IRA LLC with checkbook control is not only complex, it’s expensive. It can cost $1,500 just to set one up.
Alternatives to Self-Directed IRAs
For the average person, the variety of investments in a regular IRA — like stocks, bonds, ETFs and mutual funds — offer great opportunities for diversification at a low cost.
Regular IRAs are quick and easy to set up. Custodians are plentiful and fees are minimal. Plus they enjoy the same tax perks as a self-directed IRA.
Unless you’re a savvy crypto investor who’s comfortable navigating complex tax rules, it’s best to do your crypto investing elsewhere.
Even if you’re comfortable with IRAs, using one to buy Bitcoin or other digital currencies may not be a great idea.
High fees could eat into your returns — especially if you plan on making a lot of transactions — and negate the tax savings you’re trying to achieve.
Given all those fees, your account would need to make significant gains to justify the investment. That makes buying a risky investment like cryptocurrency even riskier.
If you believe in the long-term growth potential of Bitcoin, you’re likely better off buying the digital currency directly from an exchange and holding it yourself long-term in a hardware or digital wallet.
Most experts recommend allocating no more than 10% of your entire investment portfolio to speculative assets like cryptocurrency.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer for The Penny Hoarder.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.