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Bitcoin Investing with a Self-Directed IRA

Bitcoin Investing with a Self-Directed IRA

The first cryptocurrency was Bitcoin, which was created in 2009 and is still the best known. There has been a proliferation of cryptocurrencies in the past decade and there are now more than 1,000 available on the internet. Satoshi Nakamoto is the name used by the presumed pseudonym person or persons who developed the popular crypto, authored the Bitcoin white paper, and created and deployed it’s original reference implementation.

 
Key Points 
  • One can use retirement funds to invest in Bitcoin and other cryptocurrencies
  • You must self-direct your IRA to be able to invest in alternative assets
  • Depending on the exchange you use, you might need to set up an LLC
  • The McNulty opinion significantly limits one’s ability to hold retirement account-owned Bitcoin on a cold wallet.
 

Bitcoin has no corresponding physical element, like coins or paper bills (despite the popular image of an actual coin, above, to illustrate it). The value and verification of individual Bitcoins are provided by a global peer-to-peer network.

Bitcoin’s current goal is a store of value as well as a payment system, there is nothing to say that Bitcoin could not be used in such a way in the future.

READ MORE: Bitcoin IRA: How To Invest For Retirement With Cryptocurrency

Bitcoin is often compared to gold since it shares some crucial characteristics such as the limited supply and supply growth through mining and the non-centrality and independence of central banks.

Gold:

  • Durable/Divisible/Scarce
  • 1/2% growth a year in historical supply
  • Hard to transplant
  • Functionality – can turn in jewelry

Bitcoin:

  • Supply limited by design of its protocol
  • Borderless/Decentralized
  • Only 21 million – predictable issuance rate
  • Far more portable
  • volatile

Bitcoin Blockchain

One of the most exciting aspects of Bitcoin is the concept of blockchain. A Bitcoin holds a very simple data ledger file called a blockchain. A Block refers to a set of Bitcoin transactions from a certain time period. Blocks are “stacked” on top of each other in such a way that one block depends on the previous. In this manner, a chain of blocks is created, and thus we come to the term “blockchain”.  Below is an example of how the Bitcoin blockchain works.

  • After one sends Bitcoin using a Bitcoin wallet, this transaction information is relayed throughout the network — passes from node to node (from a server to server) until it is transmitted to all the nodes.
  • The miners (computers) then pick up this transaction information from nodes and perform a special process called mining on it, typically by using special processors called Application Specific Integrated Circuits (ASICs).
  • The transaction information is then converted into a unique 32-character length string called hash.
  • After hashing a transaction, miners then link it with the immediately preceding hash and thus create a chain of transactions after mining a few and linking them together. This chain of mined transactions is called a block.
  • The block is then linked to the previous block using the previous block hash found on the Blockchain.

Bitcoin Key Terms

  • Private Key: Secret number that allows bitcoins to be spent. Every Bitcoin wallet contains one or more private keys, which are saved in the wallet file. The private keys are mathematically related to all Bitcoin addresses generated for the wallet.
  • Public Key: The public key is used to verify the digital signature, which proves ownership of the private key.
  • Blockchain: Decentralized record-keeping technology behind the Bitcoin network.
  • Mining: Miners receive Bitcoin as incentive that motivates people to assist in the primary purpose to legitimize and monitor Bitcoin transactions, ensuring their validity.
  • Nodes: Node stores and verifies each block in the blockchain. Nodes form a network by connecting and sharing blocks and transactions with one another.
  • Hash: This is the value obtained by passing the previous hash value, the data and the nonce through the SHA-256 algorithm; it is the digital signature of the block. SHA-256 is a cryptographic hash algorithm that produces a unique 256-bit alphanumeric hash value for any given input, and that is the unique feature of this cryptographic algorithm: Whatever input you give, it will always produce a 256-bit hash.

Below we will review how you can invest in Bitcoin (and other cryptos) with your Self-Directed IRA. Please note, however, we are not telling you to invest in Bitcoin. This article is for educational information about Bitcoin investing with IRA funds. Investing in Cryptocurrencies is a very risky investment. Be sure to consult with a financial advisor to determine the best investments for your situation.

Buying Bitcoin in a Self-Directed IRA

Retirement accounts are allowed to invest in just about anything. In fact, the IRS simply tells you what you cannot invest in. These include life insurance, most collectibles and transactions involving disqualified persons (more on this later). 

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.  Thus, since an IRA and 401(k) plan can purpose property, such as stocks, cryptos are also permitted investments for retirement accounts. The sale of a cryptocurrency is not subject to tax and all gains are tax-deferred or tax-free in the case of a Roth IRA or Roth 401(k).

What Type of Retirement Accounts can be used to Buy Cryptocurrency with IRA Financial Crypto Solution?

Any IRA, Roth IRA, SEP IRA, SIMPLE IRA, a solo 401(k), or defined contribution plan (401(k), 403(b), 457(b)), so long as you have access to those funds.  In the case of a defined contribution plan, if you are seeking to use funds from an employer plan where you are currently employed, you will generally need to be over the age of 591/2 to get tax-free access to those funds.  Note – any defined contribution plan funds from a former employer can be rolled into an IRA tax-free and invested in crypto.

Tax Advantage of Buying Cryptos in a Self-Directed IRA

Investing in alternative assets with retirement funds is seen as both tax-advantageous and way to better diversify your assets. The former allows for tax-deferred growth of your gains, while the latter opens your holdings beyond the usual stocks, bonds and mutual funds.

One of the main tax advantages of using a Self-Directed IRA to invest in cryptos, such as Bitcoin is that, in general, all income and gains are tax-deferred or tax-free in the case of a Roth IRA.  In other words, an IRA would not be subject to ordinary income tax or any capital gains tax on income or crypto gains allocated to an IRA, irrespective of holding period.  For active crypto traders, using a self-directed is a huge tax advantage.  Most active Bitcoin traders will not hold the underlying asset for longer than twelve months, meaning the gains from the capital investment would be subject to short-term capital gains, which is taxed based on the taxpayer’s ordinary income tax rate.  Whereas, if the investor used a self-directed IRA to invest in Bitcoin, no tax would be due on any of the trading gains allowing the investor to take advantage of the power of tax deferral and compounding returns.

Read More: Crypto IRA Fees

Best Ways to Buy Bitcoin in a Self-Directed IRA

Bitcoin in an IRA LLC

Most crypto exchanges do not offer one the ability to open an IRA at a crypto exchange. The only legal way to purchase cryptocurrencies, such as Bitcoin, is through a regulated crypto exchange. Using an LLC wholly owned by an IRA has become a popular approach to invest in Bitcoin with retirement funds. Opening a crypto IRA using an LLC will allow the IRA owner to essentially select any cryptocurrency exchange in the U.S. as well as internationally.  In addition, using a Bitcoin IRA LLC solution will offer the IRA owner the ability to hold the Bitcoin private key on a cold wallet (see below for info on the McNulty case). Considering the FTX bankruptcy, holding one’s Bitcoin private key has become almost a requirement from a security standpoint.  This is especially important when one owns Bitcoin in a retirement account. Moreover, using a Bitcoin IRA LLC solution would allow one to open a crypto exchange account at a foreign exchange and purchase XRP and other cryptos that may not be available in the United States.  Although, one should be cautious about holding cryptos on a foreign exchange, especially considering FTX.

Below is a breakdown of how it works

  • Individual opens IRA at IRA Financial, a regulated Self-Directed IRA trust company
  • IRA would own 100% of the LLC and IRA owner would serve as manager of the LLC
  • You, as manager of the LLC, would open an account with a crypto exchange
  • IRA owner would open the LLC account at the crypto exchange (i.e. Coinbase or Binance)
  • LLC’s bank account would be linked to the crypto exchange account
  • IRA owner would have total control over the account and can hold cryptos on the exchange or pull cryptos off the exchange and hold in a cold wallet.

The Bitcoin IRA LLC is the only Self-Directed IRA crypto solution that will offer a retirement account owner with the ability to hold their crypto private key as well as use a US or foreign crypto exchange of their choice.  For more information on the rules surrounding the ability to hold your retirement account owned Bitcoin on a cold wallet, please see below.

Bitcoin IRA Direct

We are very proud to have the industry’s premier solution for buying Bitcoin and other major cryptocurrencies on an exchange in the name of an IRA or 401(k). IRA Financial was the first self-directed IRA company to allow their clients to invest in cryptocurrencies, such as Bitcoin, directly via a cryptocurrency exchange without the need for a third-party broker or the use of an LLC.  Now, investors can use their retirement funds to buy all the major cryptocurrencies directly through Bitstamp, one of the leading US cryptocurrency exchanges.  Bitstamp was founded in 2011 and is present in over 100 countries, with offices in the UK, Luxembourg, the USA, Singapore, and Slovenia, and caters to over 4 million customers across the globe.

The IRA Financial crypto solution is the first to allow retirement holders to hold cryptocurrencies in an IRA directly on an exchange.   The account is opened in the name of the IRA but controlled by you as the authorized representative on the account.  The IRA holder has 100% control over the account and can trade anytime. 

How Does the IRAFI-Bitstamp Crypto Solution Work?

Step 1: Open an IRA or Solo 401(k) account at IRA Financial Trust.

Step 2: Move IRA or 401(k) funds to new IRA Financial account tax-free.

Step 3: Funds are moved From IRA Financial to Bitstamp

Step 4: Begin buying and selling cryptos 24/7 on your own without the need for any broker or the use of an LLC on the IRA Financial app.

With the Bitcoin IRA direct solution, you can invest in cryptos directly. In other words, you do not need a costly broker or LLC. In addition, the Bitcoin will be held in the name of the IRA custodian. This will be in the benefit of the IRA holder. As a result, it’s much cleaner from a tax reporting perspective.

Advantages

  • No requirement to use broker
  • No requirement to use LLC
  • Ability to buy, sell, or exchange cryptocurrencies at any time through a PC or mobile application
  • Flat low annual IRA custodian fee – no asset valuation fees

Disadvantages

  • You can only purchase the most popular cryptocurrencies.
  • The cryptos must be held on the Bitstamp exchange

Holding Your Bitcoin Private Key in a Self-Directed IRA

The only provision in the Internal Revenue Code (“IRC”) that addresses the ability to personally possess, and IRA asset is IRC 408(m).  IRC 408(m) prohibits an IRA owner from taking personal possession of an IRS approved precious metal or coin.  The tax court in In McNulty v. Commissioner, 157 T.C. No. 10 (November 18, 2021) expanded on the concept of personal possession of an IRA asset by holding that an IRA owner cannot take personal possession of an IRA asset and cannot have unfettered control over any IRA asset.  So how does the tax court ruling in McNulty impact the ability of a retirement account investor to hold Bitcoin on a cold wallet?  The short answer – is that the court opinion would seem to potentially prohibit one from holding their retirement account owned Bitcoin on a cold wallet.

A Bitcoin cold wallet is a device that allows Bitcoin to be held offline. By using a cold wallet, Bitcoin investors can securely hold their Bitcoin off an exchange prevent hackers from being able to access their holdings via traditional means.  Considering the FTX bankruptcy and the potential for crypto exchange contagion, holding one’s Bitcoin on a cold wallet has become more important. Considering McNulty, which would seem to make holding Bitcoin owned by a retirement account in a cold wallet controlled by the retirement account owner, what are some arguments that can be made to minimize the impact of McNulty on holding retirement account owned Bitcoin on a cold wallet?

  • Cryptocurrency, such as Bitcoin is a new type of digital asset that is based off blockchain technology.  It is a unique asset because even though it is an intangible asset, it can still be held physically in a cold wallet.  Thus, applying the traditional rules of McNulty to a digital asset would be inappropriate
  • Blockchains are entirely open and accessible to everyone. Thanks to the transparency of the blockchain, it is easy to track the movement of Bitcoin. If the identity behind a Bitcoin wallet address is known, then the transactions made can be traced back and traced in the future. All these transactions can be viewed in detail.  Therefore, a retirement account owner would be able to provide to the IRS or any third-party that the crypto held in the cold wallet was not used for any personal purpose by simply providing the IRS with the Bitcoin wallet number
  • For retirement account investors seeking to use an LLC to invest in Bitcoin, moving the Bitcoin off the exchange to a cold wallet that is held at a depository, like metals could be a solution.  The advantage of this option is that you would be able to get the cryptos off the exchange and held secure in a depository that specializes in safe keeping of valuable assets, such as gold. The downside is that you do not retain total control over the wallet, although, considering the McNulty case, retaining total control is likely not a viable option.
  • The bankruptcy of FTX crypto exchange in November 2022 has created a sense of urgency amongst Bitcoin investors seeking to protect their Bitcoin from crypto exchange risk.  Bitcoin held on an exchange are controlled by the exchange and since the exchange controls the Bitcoin private key, a crypto exchange bankruptcy will put Bitcoin on the exchange at risk. For retirement account investors shielding their Bitcoin from exchange risks is even more vital since for many Americans, their retirement account is their primary source of savings.

The IRA Financial Crypto Solution

The internal technology team at IRA Financial is working on a multi-signature wallet option that will allow the retirement account owner to take personal possession of a Bitcoin wallet but would need the signature of IRA Financial to move the Bitcoin off the wallet.  This would provide the retirement account owner with ability to protect themselves from crypto exchange exposure and hacking, while at the same time satisfying the McNulty case since IRA Financial, as IRA custodian, will still maintain custody of the Bitcoin.  Of course, providing the Bitcoin owner with total control over the retirement account owned Bitcoin would be ideal, however, based on the “unfettered command” requirement in McNulty, a multi-signature approach may ultimately be the most attractive option.

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