The Internal Revenue Code does not describe what a Self Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
In essence, the IRS does not say what an IRA can invest in only what it cannot. As per IRC Section 408 and 4975, an IRA cannot invest in: (i) life insurance, (ii) collectibles, (iii) and a transaction identified under IRC Section 4975, also known as a prohibited transaction rules. The foundation of the prohibited transaction rules are premised on the notion that an IRA cannot make any investment that will involve or directly or indirectly personally the IRA holder or 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, cryptocurrencies, such as bitcoins or Ethereum can be purchased with an IRA.
Even though bitcoin and Ethereum is labeled as a “cryptocurrency”, from a federal income tax standpoint, bitcoins and other cryptocurrency are not considered a “currency.” 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 bitcoins. According to the IRS Notice, “Virtual currency is treated as property for U.S. federal tax purposes.” The Notice further stated “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, such as bitcoins, as a capital asset, subject to either short-term (ordinary income tax rates) or long term capital gains tax rates, if the asset is held greater than twelve months (15% or 20% tax rates based on income). By treating bitcoins and other virtual currencies as property and not currency, the IRS is imposing extensive record-keeping rules—and significant taxes—on its use.
Below is a step-by-step breakdown of how to use a self-directed IRA to buy cryptocurrency, such as ethereum:
- Establish self-directed IRA LLC with IRA Financial Trust & Northern Trust
- Your IRA cash/assets can be rolled over to IRA Financial Trust tax-free
- The IRA assets will then be transferred to the LLC tax-free in exchange for 100% interest in the LLC
- You as manager of the LLC will open a bank account for the LLC at any local bank. IRA Financial will draft LLC Operating Agreement identifying you as manager of the LLC and the IRA as the sole member
- You as manager of the LLC will then have checkbook control over all the assets/funds in the IRA LLC to make the bitcoin IRA investment.
Since the LLC is owned 100% by an IRA, it will be treated as a disregarded entity for tax purposes. No Federal income tax return is required to be filed and all income and gains will flow back to the IRA without tax.
The IRS tax treatment of virtual currency has created a favorable tax environment for retirement account investors. In general, when a retirement account generates income or gains from the purchase and sale of a capital asset, such as stocks, mutual funds, real estate, etc., irrespective of whether the gain was short-term (held less than twelve months) or long-term (held greater than twelve months), the retirement account does not pay any tax on the transaction and any tax would be deferred to the future when the retirement account holder taxes a distribution (in the case of a Roth IRA or Roth 401(k) plan no tax would be due if the distribution is qualified). Hence, using retirement funds to invest in cryptocurrencies, such as bitcoins could allow the investor to defer or even eliminate, in the case of a Roth, any tax due from the investment. Note – retirement account investors interested in mining bitcoins versus trading, could become subject to the unrelated business taxable income tax rules if the “mining” constituted a trade or business.
Crytocurrency investments, such as ethereum, are risky and highly volatile. Any investor interested in learning more about bitcoins should do their diligence and proceed with caution.
The IRA Financial Group was founded by a group of top law firm tax and ERISA lawyers who have worked at some of the largest law firms in the United States, such as White & Case LLP, Dewey & LeBoeuf LLP, and Thelen LLP. Over the years, we have advised thousands of clients on the Self-Directed IRA prohibited transaction and “disqualified person” rules. With our work experience at some of the largest law firms in the country, our retirement tax professionals’ tax and IRA knowledge in this area is unmatched.