An individual retirement account (IRA) is tax-advantaged savings account that individuals can open to save and invest in the long term. Similar to a 401K account that is provided to the employee by the employer, an IRA is modeled to encourage people to save for retirement. You can open an IRA via an investment company, a bank, an online brokerage, or a personal broker. However, times have changed and the IRA has evolved. With the heavy influence of cryptocurrency on our investments, it is only natural for crypto IRA, a modern spin on conventional IRAs, to become an excellent investment vehicle.
But, if you are scratching your head and thinking what a crypto IRA is, you’re not the only one! In the world of crypto, a traditional financial product like an IRA sounds too good to be true. However, under the umbrella of self-directed IRAs, U.S. citizens can invest in alternative asset classes, like real estate, precious metals, and cryptocurrency, giving birth to crypto retirement accounts. Before we get into the details of this novel IRA, let’s quickly take a look at what cryptocurrency is.
A Quick Revision on What is Cryptocurrency?
Essentially, cryptocurrency is a digital asset or a currency (as the name suggests) that you can buy, sell, or spend on goods and services. Cryptocurrency is decentralized, meaning it is free from a specific nation’s market, currency, or economy. Additionally, it runs on a blockchain, which allows you to transact from one peer to another (P2P) with its distributed ledger technology.
Within the first few years of its existence, cryptocurrency has become a legitimate investment vehicle for investors around the world. Even financial institutions are warming up to crypto. With the brief explanation of cryptocurrency out of the way, let’s move on to how crypto retirement accounts work.
How Does a Crypto IRA Work?
Like in a traditional IRA where you invest your fiat currency, a crypto retirement account is where you invest and store crypto instead. It follows the same standards as a usual asset class IRA, including the tax benefits. Still, there are some differences which include the storage—as with any other cryptocurrency, your digital assets will be stored in a digital wallet—and a crypto exchange is involved in conjunction with a custodian, your IRA holder.
What are the Benefits of a Crypto IRA?
Along with several benefits, crypto retirement accounts have some pitfalls as well. Cryptocurrencies have always sparked environmental concerns and an uneven global attitude toward crypto recognition always leads to its volatility. But gradually, crypto has garnered popularity, value, and legitimacy in major parts of the world. If this uptrend continues, crypto retirement plan investors can reap huge potential returns come retirement. Other than potentially high returns, this investment has other advantages such as:
- Tax benefits
- Portfolio Diversification
Let’s understand them in detail now.
For investors who are actively looking for ways to dampen their crypto taxes, a crypto IRA is one of the safest ways to achieve it. Since crypto is listed as a property by the Internal Revenue Services (IRS), whatever you earn is subjected to either short-term or long-term capital gains tax. However, if you invest your digital assets in a traditional or a Roth IRA you will see tax benefits. Roth IRA is an exceptional way for individuals to save for retirement and withdraw the money tax-free after retirement.
Both traditional and Roth crypto IRAs have tax benefits but they differ in offering the said benefit. In a traditional crypto IRA, the tax benefits are more immediate because you don’t have to pay the taxes until you access the funds when you retire. On the other hand, Roth crypto IRA offers greater tax benefits down the road because your contributions are not tax-deductible so you avoid paying the capital gains tax if the value of the cryptocurrency appreciates in the future.
If you want to minimize your crypto taxes even further, then you can adopt the crypto tax-loss harvesting strategy where you can sell your assets for a loss to counterbalance your capital gains. A cryptocurrency tax software like ZenLedger can be highly useful in this situation as it can identify tax-loss harvesting opportunities during the year, monitor your crypto portfolio, and when the tax season arrives, it can auto-generate your tax forms.
Blockchain is known for its secure transfers between two parties with nominal risk of tampering. The blocks that make the blockchain are built upon the information of the previous block, so modifying the data of a block requires manipulating the entire chain, making the transactions secure, easy to monitor, and verify as authentic. Blockchain has other applications but conducting secure transactions makes it highly appreciated in many sectors especially in the financial space where large amounts of capital transfer may otherwise be at risk.
A diversified portfolio designed to your tolerance of risk as well as your overall financial goals is the benchmark of a successful investment strategy. Solely investing in a crypto retirement account or along with a conventional retirement plan is an excellent way to increase your returns.
What Are the Potential Risks of a Crypto IRA?
It is always best to be aware of the risks related to any investment that you make, especially when choosing cryptocurrency investments as a big chunk of your retirement plan. Here are a few disadvantages of the crypto retirement account.
Let’s take a detailed look at them.
Cryptocurrency is decentralized in nature and for this very reason, it is volatile. It is quite evident that a simple tweet from the right (or wrong) person can disrupt crypto prices quickly. Typically, a normal investment portfolio or a retirement account is a blend of the carefully chosen ratio of asset classes consisting of many companies. This implies that if a company or a sector implodes, the value of your portfolio won’t plummet.
However, based on how you invest in crypto, a bad press day could be troublesome for your crypto retirement account if you don’t adopt the right strategies. Every investment and trading strategy suggests not to put all your eggs in one basket. Protecting yourself against volatility by making a larger strategy designed to handle the ups and downs of the crypto market is ideal.
Normal IRAs allow you to invest for free but self-directed IRAs generally come with fees or charges. There are several fees such as setup fees, account management fees, and more. Make sure you are not blindsided by the fees associated with the crypto retirement account.
You have to handle the moving parts of exchanges, secure storage, and custodians. On top of that, you have to maintain another retirement account because self-directed IRAs aren’t set up for traditional assets such as mutual funds, stocks, and bonds, adding a layer of complexity to your retirement plan.
How do Crypto IRA Taxes Work?
For a better understanding of crypto retirement accounts and taxes, you have to understand the tax status of several retirement accounts and crypto tax law. Remember, the IRS sees cryptocurrency as property, so it is subjected to capital taxes the same as other assets. However, IRAs are different as they are tax-advantaged, but it depends on which type of IRA you select. The two most common types of IRA are Traditional and Roth IRAs and each has its own tax benefits.
Traditional Crypto IRA
Your contributions are tax-deductible if you have a traditional crypto retirement account. This alludes to the fact that you can deduct your yearly contributions from your taxable earnings and until you withdraw your funds, you don’t have to pay income taxes. If you withdraw your funds before retirement, you are liable to a penalty and taxes based on the value of funds you withdrew. The annual contributions are based on your annual income and filing status.
Roth Crypto IRA
You can steer clear of capital gains taxes on your income with a Roth Crypto IRA and the distributions you receive at the time of retirement are nontaxable. However, you cannot deduct your contributions from the annual income.
How to Open a Crypto IRA?
After deciding that you want to open a crypto retirement account, you need to find a custodian that hosts your self-directed IRA. Several places help you open a crypto retirement account such as:
- Bitcoin IRA
- Coin IRA
- Equity Trust
Similar to opening a brokerage account, you have to provide your full legal name, date of birth, address, Social Security Number, and banking details. When choosing a crypto retirement account custodian, make sure that tokens available, account types, and exchanges that they offer are aligned with your goals. Also, remember to calculate and compare any relevant fees since they add up over the years and can impact your retirement goals.
Should You Open a Crypto Retirement Account?
For individuals who are close to retirement, opening a crypto retirement account might not be the most prudent option as cryptocurrencies are quite volatile. However, if someone has higher risk tolerance and has a longer time horizon, investing a small portion of their savings in cryptocurrencies could offer an upside and protect them from the losses of conventional holdings.
It must be kept in mind that crypto retirement accounts have a lot of moving parts compared to conventional retirement accounts. This means that you have to be extra diligent not only while researching the right cryptocurrency but also when choosing the right IRA provider. Also, confirm relevant fees as many providers are not transparent about them on their websites. And, perhaps most importantly, consider crypto retirement accounts as a part of your retirement plan, not its entirety.
Investing in a crypto retirement account in conjunction with a traditional IRA is an excellent way to diversify your portfolio while minimizing your crypto taxes. Having said that, whether it is a conventional IRA or a crypto IRA, you should get started with a retirement account—regardless of your age—to save for your retirement and enjoy the golden years.
ZenLedger can help you easily calculate your crypto taxes, and also find opportunities for you to save money and trade smarter. Get started for free now or learn more about our tax professional prepared plans!