If you've decided that the risks of Bitcoin (BTC -3.97%) are worth the rewards, you might be worried about getting hit with a big tax bill. When you trade Bitcoin, you're subject to capital gains taxes, which could be substantial given the cryptocurrency's wild ups and downs.
One work-around is to invest in a Bitcoin IRA, or individual retirement account. As with any IRA, you're shielded from paying taxes on transactions within the account. But is that enough to justify the risks of investing your IRA funds in Bitcoin?
What is a Bitcoin IRA?
A Bitcoin IRA is basically just a self-directed IRA, which is an IRA that allows you to invest in alternative assets like cryptocurrency, real estate, and physical gold. Though one platform has trademarked the name Bitcoin IRA, there are multiple brokerages that allow you to invest in crypto with a self-directed IRA.
Per IRS rules, you can't transfer crypto holdings into a self-directed IRA. You'll need to fund the account with U.S. dollars, then buy Bitcoin in your IRA.
Imagine if you had maxed out your Roth IRA with Bitcoin in 2016, when the contribution limit for someone younger than 50 was $5,500. Even after last month's crypto crash, as of June 6, 2021, your investment would be worth more than $330,000 -- all yours, tax-free in retirement if you follow the Roth IRA rules.
What are the downsides of a Bitcoin IRA?
The problem with investing retirement money in Bitcoin is that today's $330,000 nest egg might be worth a lot less when you need it. Bitcoin is a highly volatile investment.
The stock market undergoes a correction, meaning a drop of 10% or more, roughly once every two years. By comparison, Bitcoin has crashed by 50% or more six different times since 2012, according to Visual Capital. Three times it tanked by over 80%. As evidenced by the example above, it's historically bounced back and delivered huge returns over time thus far. But those returns have been highly unpredictable.
Bitcoin remains speculative because its real-world utility remains so limited, plus there are thousands of other cryptocurrencies. Where Bitcoin will be five or 10 years from now is anyone's guess.
Meanwhile, the stock market's returns are pretty predictable in the long term. The S&P 500 index delivered average annualized returns of about 10% over the past 50 years. Those returns may pale in comparison to what we've seen from Bitcoin in recent years, but in retirement planning, achieving predictability is essential.
When does a Bitcoin IRA make sense?
First and foremost, investing in Bitcoin in an IRA or anywhere else only makes sense if you've carefully assessed your risk tolerance and decided you can stomach huge swings. You can assess your risk tolerance using this calculator. Bitcoin is only appropriate if your risk profile is very aggressive.
Also make sure you consider the hefty fees of investing in a Bitcoin IRA against the tax advantages. Many charge setup fees, maintenance fees, and transaction fees, plus they often have significant account minimums.
In general, speculative assets shouldn't make up more than about 5% to 10% of your overall investment portfolio. So if you have significant crypto holdings outside of your IRA, steer clear of a Bitcoin IRA.
Only consider it if you're on track to retire comfortably with savings from other retirement accounts, like a 401(k) or 403(b). If there's any chance you'll need your IRA money to fund your golden years, that money shouldn't be invested in Bitcoin.
Likewise, avoid investing in Bitcoin if you plan to use the money for other purposes, like a first-time home purchase or your child's college tuition, both of which are popular uses for a Roth IRA.
Even if Bitcoin makes sense for you as an investor, a Bitcoin IRA probably isn't a good way to invest your retirement money.