The Ethereum Merge & Your Self-Directed IRA

The Ethereum Merge & Your Self-Directed IRA

The Ethereum merge is finally upon us after years of delays and false starts.  The great news is that the Ethereum merge will make it far more energy efficient and it will have no impact on any current owner of Ethereum in or outside of a Self-Directed IRA. This article will explain, in simple terms, all you need to know about the merge and briefly discuss the impact, if any, on Self-Directed IRA Ethereum investors.

Key Points
  • Finally, the Ethereum merge is here
  • Ethereum is moving from a proof-of-work to a proof-of-stake system
  • The impact of the merge on Self-Directed IRA investors is minimal

What is Ethereum?

Ethereum is the second most popular cryptocurrency after Bitcoin. In 2013, Vitalik Buterin published a whitepaper that conceptualized “A Next-Generation Smart Contract and Decentralized Application Platform.”

Smart contracts are at the heart of the popularity of Ethereum.  They allow participants to transact with each other without a trusted central authority, such as bank. Transaction records are absolute, verifiable, and securely dispersed across the network, giving participants full ownership and visibility into transaction data. Transactions are sent from and received by user-created Ethereum accounts.

Initially launched with a proof-of-work (PoW) consensus algorithm in 2015, the vision of Ethereum has always been for it to become an energy efficient proof-of-stake (PoS) network.

What is Proof-of-Work?

Prior to September 15, 2022, Ethereum, like Bitcoin, used a consensus protocol called PoW. The PoW system allows the nodes of the Ethereum network to agree on the state of all information recorded on the Ethereum blockchain and prevents certain kinds of economic attacks. In other words, proof-of-work is the means that allows the decentralized Ethereum network to come to consensus on things like account balances and the order of transactions. This prevents users from “double spending.”

Proof of work is the underlying algorithm that sets the difficulty and rules for the work miners do. Mining is the “work” itself. Ethereum miners – computers running software – using their time and computation power to process transactions and produce blocks

What is Proof-of-Stake?

As discussed, above, PoS is a type of consensus system used by the Ethereum blockchains to achieve distributed consensus. In PoW, miners prove they have capital at risk by expending energy. In proof-of-stake, validators explicitly stake capital in the form of ether into a smart contract on Ethereum.

This staked ether then acts as collateral that can be destroyed if the validator behaves dishonestly or lazily. The validator is then responsible for checking that new blocks propagated over the network are valid and occasionally creating and propagating new blocks themselves.  The idea behind POS is that since you are using the ether you own as collateral for being a validator of an Ethereum block of transactions, you will not risk acting dishonestly so as to not risk your staked ether.

According to their website, this is how the Ethereum POS will work:

To participate as a validator, a user must deposit 32 ETH into the deposit contract and run three separate pieces of software: an execution client, a consensus client, and a validator. On depositing their ether, the user joins an activation queue that limits the rate of new validators joining the network. Once activated, validators receive new blocks from peers on the Ethereum network. The transactions delivered in the block are re-executed, and the block signature is checked to ensure the block is valid. The validator then sends a vote (called an attestation) in favor of that block across the network.

The belief is that a POS system is more secure, less energy-intensive, and better for implementing new scaling solutions than a PoW.  One of the major benefits of the PoS framework will be a stark reduction in the network’s energy usage to the tune of 99.95%.

Ethereum Blockchain – A History

Th Mainnet Ethereum blockchain is the blockchain every Ethereum investor is used to. The Mainnet Ethereum blockchain contains every transaction, smart contract, and balance since it began in July 2015.

Throughout Ethereum’s history, developers have been diligently preparing for an eventual transition away from PoW to PoS. On December 1, 2020, the Beacon Chain was created, which has since existed as a separate Ethereum blockchain to Mainnet, running in parallel.

The Ethereum Merge represents the official switch to using the Beacon Chain as the engine of block production. Mining will no longer be the means of creating valid blocks. Instead, the PoS validators will undertake this role and will be responsible for processing the validity of all transactions and proposing blocks. Once the Ethereum merge happens, validators will be assigned to secure Ethereum Mainnet, and mining on PoW will no longer be a valid means of block production. The important thing of the Ethereum merge is that no history is lost. As Mainnet gets merged with the Beacon Chain, it will also merge the entire transactional history of Ethereum. 

What is a Self-Directed IRA?

A Self-Directed IRA simply refers to an IRA account which is permitted to be invested in alternative assets, such as real estate and cryptos.  The Self-Directed IRA industry has grown in popularity significantly over the last twenty years or so which coincides with the growth in importance of alternative assets as a source of investment diversification.

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IRS & Cryptos in a Retirement Account

In IRS Notice 2014-21, the IRS issued guidance on the tax treatment of cryptos.  In the Notice, the IRS confirmed that cryptos, such as Bitcoin would be treated from a tax perspective as a capital asset, such as property, like a stock or real estate.  Hence, cryptocurrency, like stocks, may be purchased in a retirement account. The sale of a cryptocurrency is not subject to tax and all gains are tax-deferred (or tax-free for qualified Roth distributions).

In March 2022, the Department of Labor (DOL) issued guidance to 401(k) plan fiduciaries warning them to exercise extreme care before they consider adding a cryptocurrency option to a 401(k) plan’s investment menu for plan participants.

Release 2201-01 did not prohibit 401(k) plan from investing in cryptocurrencies, but did caution plan fiduciaries to exercise extreme care when considering cryptos as a 401(k) plan investment. Note – Release 2201-01 did not reference IRAs or Solo 401(k) plans, which are not subject to ERISA.

Self-Directed IRA Holders of Ethereum

The best part of the Ethereum merge is that any holder of Ethereum, whether an individual or a retirement account, does not need to do anything. Your funds are safe. The Ethereum merge is one of the most noteworthy and awaited upgrades in the history of cryptos, and although in the long-term its impact will be felt by everyone, in the near-term Ethereum investors do not need to do anything to prepare. 

To be clear, all Ethereum investors, including those investing with a Self-Directed IRA or a Solo 401(k) do not need to do anything to protect your funds entering the merge.

Essentially, the PoS system will take the place of the PoW validation of transactions. Nothing else changes and the history of Ethereum will stay as it is. Funds held in your wallet before the merge will still be accessible after the merge; you don’t need to do a thing.

Conclusion

It’s finally here! Once completed, the PoW consensus layer in Ethereum will be removed and consensus on all future blocks on the Ethereum blockchain will be achieved by the new PoS consensus layer. None of the transactions done on the Ethereum network will be lost in this transition. The Ethereum merge will have no effect on the Ethereum you own in your retirement account.

The merge is not the launch of a new Ethereum version, but rather an exciting upgrade to the consensus layer – bringing Ethereum in line with the original vision laid out at its onset.

The merge from PoW to PoS is expected to make Ethereum far more energy efficient and more scalable. The best part of it is that no action is required on the part of any Ethereum holder.

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