With the recent downfall of FTX and governmental lawsuits against several cryptocurrency exchanges, many investors have begun to inquire whether the IRS has banned IRAs or 401(k) plans from investing in cryptos. This article will explore the current IRS and Department or Labor (DOL) rules and positions on digital currency in a retirement account.
- There is little legislation from the IRS and DOL regarding cryptocurrency
- What we do know is that cryptos and other digital assets are treated as property for tax purposes
- Because of volatility, the DOL recommends fiduciaries of ERISA-based plans to use caution when selecting cryptos as an investment option
Prior to Notice 2014-21, the tax treatment of cryptocurrencies was not clear. According to a May 2013 General Accountability Office report (GAO-13-516) virtual economies and currencies pose various tax compliance risks, but the extent of actual tax noncompliance is unknown. The report spent considerable time focusing on Bitcoin and the potential tax implications of investing or using Bitcoin in a commercial setting.
The report essentially concluded that there needed to be greater IRS guidance on the taxation of Bitcoin and other cryptos. In addition, because of the increasing use of virtual currencies, the GAO report recommended that the IRS find low-cost ways of providing information to taxpayers on the basic tax reporting consequences of using virtual currencies.
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 Bitcoin. According to the IRS Notice, “Virtual currency is treated as property for U.S. federal tax purposes. 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 as a capital asset, subject to either short-term (ordinary income tax rates) or long-term capital gains tax rates, (15% or 20% tax rates based on income). By treating virtual currencies as property and not currency, the IRS is imposing extensive record-keeping rules – and significant taxes – on its use.
Whereas, if one uses an IRA or 401(k) to buy cryptos, there would be no tax on the gain, and therefore no need to worry about holding periods.
Notice 2014-21 was very important for retirement accounts because it confirmed that a retirement account was permitted by the IRS to invest in Bitcoin and other cryptos since they would be treated as property, such as stocks and real estate, from a federal income tax perspective.
Revenue Ruling 2019-24
From 2014-2019, the IRS did not issue any formal notice or ruling on the taxation of cryptos. However, in Notice 2019-24, the IRS issued a ruling on the tax treatment of a cryptocurrency hard fork.
A hard fork is unique to distributed ledger technology and occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. A hard fork may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.
The Ruling held that so long as the crypto holder does not gain control over the new cryptos, the transaction would not become taxable. Whereas, if the crypto owner later acquires the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, the taxpayer is treated as receiving the cryptocurrency at that time.
Compliance Assistance Release (CAR) 2022-01
On March 10, 2022, the Department of Labor (DOL) released Compliance Assistance Release (CAR) 2022-01, which specifically addressed 401(k) plan investments in cryptocurrencies. The primary purpose of CAR 2022-01 is to put plan fiduciaries of 401(k) plans on notice to exercise “extreme care” in considering cryptocurrencies as part of a 401(k) investment options for plan participants.
Under ERISA, fiduciaries must act solely in the financial interests of plan participants and adhere to an exacting standard of professional care. In general, fiduciaries who breach those duties are personally liable for any losses to the plan resulting from that breach. A fiduciary’s consideration of whether to include an option for participants to invest in cryptocurrencies is subject to these exacting responsibilities.
CAR 2022-01 does not differentiate between the different types of crypto assets, such as Bitcoin or NFTs. ERISA rules require that the value of a participant’s 401(k) plan retirement account depends on the investment performance of the employee’s and employer’s contributions.
When a 401(k) plan offer a variety of investment options to plan participants, the responsible fiduciaries have an obligation to ensure the prudence of the options on an ongoing basis. Fiduciaries may not shift responsibility to plan participants to identify and avoid imprudent investment options. The CAR went on to say, “due to the fact that cryptocurrency industry is in its early stages, the DOL has serious concerns about the prudence of a fiduciary’s decision to expose 401(k) plan’s participants to direct investments in cryptocurrencies, or other products whose value is tied to cryptocurrencies.”
The DOL also mentioned that it expects to conduct an investigative program aimed at 401(k) plans that offer participant investments in cryptocurrencies and related products, and to take appropriate action to protect the interests of plan participants and beneficiaries with respect to these investments.
It is important to note that CAR 2022-01 does not prohibit or ban 401(k) plans from offering cryptocurrency investment to plan participants. However, it does suggest that any 401(k) plan that does offer cryptocurrency investments be cautious and make sure that the plan fiduciary and each plan participant fully understands the risks involved, including volatility, knowledge base, custodial concerns, and valuation concerns.
Impact of CAR 2022-01 on IRAs & Solo 401(k) Plans
CAR 2022-01 only addresses ERISA-regulated 401(k) plans and does not cover any types of IRAs, or the Solo 401(k) plan since they are not subject to the ERISA rules. In other words, since a Solo 401(k) plan is adopted by a business with no full-time employees, the DOL has no regulatory authority over the plan. Nevertheless, it is still important to understand the risks involved in using a Solo 401(k) plan to make crypto-type investments.
Fallout from CAR 2022-01
ForUsAll Inc. filed a lawsuit on June 2, 2022 in U.S. District Court in Washington, D.C., against the Labor Department, which regulates 401(k)-type plans. The San Francisco company is a 401(k) administrator; it has said it plans to let workers in retirement plans it administers invest up to 5% of their 401(k) contributions in cryptocurrencies. The lawsuit contends the DOL’s March 10 guidance is overly aggressive, since it weighs in on the merits of a particular type of investment.
On April 12, 2022, a letter from financial industry trade groups, including the Investment Company Institute, which represents mutual-fund companies, asked the DOL to withdraw the March 10 guidance. Furthermore, Ali Khawar, acting assistant secretary of the department’s Employee Benefits Security Administration, said in an interview with The Wall Street Journal that the agency isn’t banning cryptocurrency in 401(k) plans.
IRS Notice 2014-21 was the first IRS ruling that clearly held that a retirement account can invest in cryptocurrencies, just as it can invest in any capital asset, such as real estate or stocks. Otherwise, CAR 2022-01 was the only other public announcement on the use of a 401(k) to invest in cryptos.
It is important to note that the IRS, nor the DOL, have banned cryptos as an investment option for IRAs or 401(k) plans. However, because of its volatility and limited regulation, the DOL is cautioning ERISA 401(k) plan fiduciaries interested in offering crypto options to their employees.
Obviously, if you have an IRA or Solo 401(k) plan, you must use your own judgement about the merits of investing in cryptos and other digital assets. But this can be said about any other asset class out there. So long as you understand the risks involved with the investment, it’s up to you to decide whether or not you can live with the volatility.