Cryptocurrencies are becoming increasingly mainstream. For instance, the SEC began approving Bitcoin futures-based ETFs and robo-advisors have been buying up crypto-focused asset management firms. However, most of these funds employ buy-and-hold or long-only strategies, and they solely invest in Bitcoin, Ethereum, or a handful of other prominent cryptocurrencies.
Self-directed IRAs, or SDIRAs, are traditional or Roth IRAs that let you invest in more than stocks, bonds, mutual funds, or other standard investments. Using these accounts, you can directly buy and sell cryptocurrencies on an exchange (along with other alternative assets) while realizing the tax benefits of an IRA.
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How to Set Up a Crypto SDIRA
Many of the largest brokerages don’t offer SDIRA accounts. Instead, you’ll likely have to deal with specialized companies that deal in specific alternative assets. For example, Equity Trust Company and IRA Financial specialize in cryptocurrencies, along with private equity, real estate, and other alternative asset classes.
The process of setting up an account typically involves:
- Establishing and funding an SDIRA with a custodian
- Registering an LLC that will be 100%-owned by the SDIRA; all income and expenses will run through the LLC, but it will carry the same tax-advantaged status as the IRA
- Opening a business checking account using funds from the IRA; these funds will be used solely for investing in SDIRA assets, such as cryptocurrencies or real estate
- Opening a cryptocurrency account with an exchange in the LLC’s name and making transactions through that account
Given the complexity of setting up these accounts, most people work with their financial advisors or attorneys, especially since most SDIRA owners are high-net-worth individuals interested in alternative assets. However, it’s possible to set up these accounts on your own using off-the-shelf services or by working with custodians themselves.
Crypto SDIRA Risks
SDIRAs provide a lot of flexibility, but they also eliminate many safeguards put in place by conventional IRAs. In addition, cryptocurrencies tend to be much more volatile than blue-chip stocks or mutual funds. As a result, crypto SDIRA account holders should tread carefully when establishing and trading from these accounts.
Some risks to keep in mind include:
- Prohibited Transactions – You cannot borrow money from an SDIRA, sell property to it, or make other ‘self-dealing’ transactions. For instance, you transfer cryptocurrencies between your other accounts in exchange for cash from the SDIRA.
- Fraudulent Custodians – SDIRA custodians are lesser-known brands than traditional brokerages. As a result, a great deal more fraud takes place, meaning that it’s essential to do your due diligence and ensure you’re working with a reputable partner.
- Active Management – SDIRAs require you to actively manage them over time. For instance, you may need to rebalance your long-only crypto portfolio to maintain asset allocations or execute trading strategies to capitalize on DeFi or other opportunities.
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Alternatives to Consider
Investors looking for maximum flexibility and tax advantages won’t find anything better than an SDIRA, but there are some alternatives to consider that offer similar benefits. For example, many active ETFs focus on cryptocurrency or blockchain technologies, providing dynamic exposure to the market that’s not simply buy-and-hold.
Some popular active ETFs include:
- Amplify Transformational Data Sharing ETF (BLOK)
- First Trust SkyBridge Crypto Industry and Digital Economy ETF (CRPT)
- Valkyrie Bitcoin Strategy ETF (BTF).
Of course, you can also buy and sell cryptocurrencies outside of an IRA. While you have to pay capital gains taxes, you could offset some of these obligations using tax-loss harvesting and other techniques. And, of course, you also have the flexibility to withdraw money before retirement without incurring any penalties.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
The Bottom Line
Cryptocurrencies are becoming more popular among investors, but regulations limit their exposure. SDIRAs provide a workaround for sophisticated investors who want the flexibility to invest in any cryptocurrency and the tax advantages of an IRA. However, there are several risk factors to keep in mind along the way.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
