After U.S. lawmakers reintroduced the Financial Freedom Act in mid-February, there is fresh debate about the role crypto should play in retirement plans. The goal of the Financial Freedom Act is simple: Let Americans invest their retirement savings how they want, even if it means investing in crypto. 

There's just one problem with that. Right now, the official guidance from the U.S. Department of Labor is that employers should not offer any crypto options in their 401(k) plans. Moreover, at the beginning of February, a trio of regulators -- the SEC, the North American Securities Administrators Association, and the Financial Industry Regulatory Authority -- warned against crypto exposure in self-directed individual retirement accounts (IRAs). With that in mind, here's a closer look at the pros and cons of adding cryptocurrencies such as Bitcoin (BTC 1.49%) to your retirement portfolio.

Pros of adding crypto to your retirement portfolio

The overwhelming advantage to adding crypto to a retirement portfolio is the opportunity for truly life-changing gains. For example, over the period from 2011 to 2021, Bitcoin was the top-performing asset class in the world, and it wasn't even close. Over that time period, Bitcoin delivered annualized returns of 230% to investors. In comparison, the next-best asset class (big tech stocks) returned only 20% on an annualized basis. 

Orange Bitcoin symbol on Wall Street.

Image source: Getty Images.

If you're behind schedule on your retirement savings, or if you are planning on retiring early, it's easy to see the allure of investing in crypto. Rather than investing for 30 years in a relatively safe asset class and methodically churning out returns in order to save for retirement, Bitcoin theoretically gives you the option of investing for maybe 10 years and having a big enough nest egg to settle down and retire comfortably.

Cons of adding crypto to your retirement portfolio

Of course, this type of thinking assumes two key things. One, it assumes that past returns are a reliable predictor of future returns. But that's not necessarily the case with crypto, which has a relatively short track record. Sure, Bitcoin might have a nearly 15-year track record, but newer altcoins come and go. Moreover, we don't really know how Bitcoin is going to perform in the future.

Secondly, by putting a significant portion of your retirement assets into crypto, you are ignoring the fact that the crypto market is extremely volatile. At just the moment that you think you've reached your retirement savings goals, you could have your precious nest egg snatched away from you.

The past two years are a great example of this volatility at work. After a banner year in 2021, when just about every crypto approached all-time highs, the crypto market suffered through a house of horrors in 2022. Nearly every major crypto -- even Bitcoin -- fell by 65% or more last year. That means your retirement savings would have been largely wiped out if you were counting on crypto to finance your retirement.

Another big disadvantage to adding Bitcoin to your retirement portfolio is that there are few formal options available from top financial institutions. As long as the U.S. Department of Labor refuses to give a seal of approval to crypto for 401(k) plans, employers are going to be very leery about offering these plans. They have a fiduciary duty to protect their employees, and right now, crypto is not viewed as a responsible way to exercise that fiduciary duty. 

As a result, individual investors are left with a DIY approach. In practical terms, this means opening up an account with a major cryptocurrency exchange and designating all funds in that account for retirement. But what happens if that cryptocurrency exchange turns out to be the next FTX (FTT 5.52%) and fails? Or what if you're investing in a lot of speculative altcoins instead of more trusted names like Bitcoin because you don't have access to professional investment advice?

Shifting sentiment in Washington?

Based on the above, it's easy to see why there is such a contentious debate happening right now around the topic of crypto in retirement accounts. On one hand, you have free market advocates, who think the government should stay out of the game and the free market should decide what happens next. They point to examples like Fidelity Investments, which led the way in April 2022 with the introduction of crypto retirement plan offerings for employers.

On the other hand, you have the supporters of government intervention, who think the government has an important role to play in protecting individual investors from losing their retirement nest eggs. They point to examples like the recent meltdown of FTX as proof that investing in crypto is fraught with peril.   

The 5% rule

Keep an eye on this space. Things could change soon if the Financial Freedom Act eventually passes. For now, a good rule of thumb is that, for DIY individual investors, the maximum amount of retirement savings that should be allocated to crypto is 5%. This is the cap currently proposed by many financial advisors, and it ensures that the overwhelming majority of your retirement portfolio is tied up in less risky and less speculative assets. Thus, even if Bitcoin goes to $0, you won't face a complete obliteration of your retirement portfolio.