It is possible to use a self-directed IRA to purchase cryptocurrency. Keep in mind that those who do decide to go forward with this should recognize that it does come with risk and volatility. Therefore, it is at one’s own risk.

The Basics Of Cryptocurrency

Before delving into what it takes to using a self-directed IRA to purchase cryptocurrency, it is important to discuss the basics of cryptocurrency. These days, most individuals purchase cryptocurrency through exchanges. Most exchanges first require users to verify their account and upon doing so, individuals can select a payment method to purchase the digital currency. The only modes of payment that are not accepted are bank accounts and wire transfer.

Cryptocurrency is placed in exchanges through the mining process. Essentially, computer processing power is used to solve complex algorithms that are known as “blocks.” Once the cryptocurrency is placed on the exchange, it can be bought and sold and used for purchases.

Tax Treatment Of Cryptocurrency

A major issue that tends to arise when individuals purchase cryptocurrency with non-retirement funds is whether the transaction is taxable. Essentially, although Bitcoin is considered a “cryptocurrency” under the federal income tax guidelines, it is not considered a currency. In November 2014, the Internal Revenue Service released Notice 2014-21, which discusses the agency’s position on the taxation of virtual currencies.

The notice explains that,

“virtual currency is treated as property for U.S. federal tax purposes”

and

“general tax principles that apply to the property transactions apply to transactions using virtual currency.”

Essentially, the income gains from the sale of cryptocurrency are subject to short-term income tax rates or long-term capital gains tax rates. For the latter to apply, the asset must be held for more than twelve months.

A Bitcoin IRA To Invest In Cryptocurrency

The good news for retirement account investors is that the IRS’s treatment of virtual currency is beneficial. Retirement accounts that generate income or gains from purchases or sales of capital assets do not pay tax on the transaction. Any tax that would be applied would be deferred to when the retiree taxes a distribution. Accordingly, those who use retirement funds to invest in cryptocurrencies can defer tax from the investment. Keep in mind though that investors who mine Bitcoin instead of trading could be subject to tax if “mining” is considered a trade of business.

The Process Of Using A Self-Directed IRA To Invest In Cryptocurrency

There are a number of steps involved in this process and it is important to note that the best method is to refer to a financial advisor. But generally, here are the steps:

  • Create a self-directed IRA
  • Rollover retirement funds to the account
  • Turn the IRA into an LLC
  • As the manager of the LLC, open a bank account for the LLC and have an operating agreement to identify oneself as the manager and sole member

Accordingly, the LLC is an IRA and it will be treated ad such for tax purchases. The income and gains generated will be tax-free. Again – it is best to discuss the matter and how to proceed with a financial advisor.

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