Matthew Frankel

The Motley Fool

Digital currencies such as bitcoin have surged in popularity in recent years, and many people are buying them with the intention of holding for the long run, hoping for further price appreciation. For long-term investors, it is possible to invest in bitcoin and other digital currencies through individual retirement accounts, or IRAs, which have several benefits over simply buying digital currencies on a bitcoin exchange.

Here's an introduction to digital IRAs, the broader category of self-directed IRAs, and reasons you might want to use (or not use) an IRA to invest in digital currencies.

What is a digital IRA?

A digital IRA is a type of self-directed individual retirement account that is designed to allow investors to invest in digital currencies such as bitcoin and Ethereum. The IRS characterizes digital currencies such as bitcoin as personal property, which allows for them to be held and treated as investments, so allowing for their investment in an IRA is a logical next step.

Because digital IRAs are relatively new, I recently spoke with George Harris and Andy Klein of digital IRA provider First Digital IRA to learn more about this new option for retirement savers.

Not just for digital currencies

This is perhaps the most important point to know about digital IRAs. One popular misconception, and one that I admit I had before speaking with the First Digital IRA team, is that the digital IRA concept is intended so that investors can open an IRA that only holds digital currencies. In other words, I thought that a client might deposit $3,000 in a new IRA and invest the entire sum in bitcoin. That is 100% false.

In fact, First Digital's team tells me that most people who have opened digital IRAs allocate just a small percentage of their assets to bitcoin and other digital currencies — they simply want to have it as an option.

Self-directed IRAs are different from what you would normally think of when you hear the term "IRA," in that a much wider variety of investments are available. In a self-directed digital IRA, you can hold investments such as the traditional choices of stocks, bonds, and mutual funds, as well as other assets such as real estate, private businesses, and precious metals, just to name a few. In other words, self-directed IRAs, such as the digital IRAs First Digital IRA offers, give investors a tremendous ability to diversify their retirement assets.

To be clear, self-directed IRAs have their pros and cons, and if you're interested in learning more, here's an excellent explanation from my colleague Dan Caplinger.

Reasons to use an IRA to invest in digital currencies

As someone who has purchased bitcoin through an exchange — Coinbase, to be specific — and found the process to be fast and convenient, I asked the team at First Digital IRA why someone might be better off investing through an IRA.

The most obvious reason to use a digital IRA to invest in digital currencies, as opposed to simply buying them through an exchange, is for the tax advantages. For as long as your money stays in the IRA, you won't pay any tax on profits your investments earn. You only may have to pay tax when you eventually take a distribution.

On the same topic, a self-directed digital IRA can be structured as either a traditional or Roth IRA, so you can choose whether you want your tax deduction now or if you would rather have tax-free withdrawals in retirement. The same rules apply as with a conventional IRA, in terms of contribution limits and withdrawal restrictions.

Another advantage is the ability to buy an unlimited amount of digital currency almost instantly. Exchanges tend to set limits for most customers, and in fact, I use Coinbase and my daily bitcoin purchase limit is $100. With a digital IRA, this isn't an issue.

Finally, another big advantage is security. Without getting too deep into the technical side of digital currency security, First Digital IRA stores all of investors' digital currencies in heavily encrypted wallets. Simply put, it's extremely difficult for thieves to break through the type of security First Digital has in place.

Should you use a digital IRA?

I've written many times before that while the vast majority of anyone's retirement assets should be in blue-chip stocks, bonds, and similar lower-risk assets, there's nothing wrong with speculating with a small portion of your savings — as long as it's with money that you can afford to lose if things don't go your way. After all, bitcoin has risen from roughly $200 to nearly $4,000 in just a few years, and it's certainly not impossible for the opposite to happen. I've made the case before that bitcoin could potentially be worth $1 million someday, but to be clear, I think it's equally likely that it could be worth far less than it is now.

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My point is that it isn't a bad idea to use a digital IRA to invest in bitcoin or another digital currency, provided that:

You thoroughly understand digital currencies and the risk involved with them. "A digital IRA is appropriate for someone who is educated about digital currencies and understands what they're getting into," says Klein.

You open your digital IRA with a reputable company. As Harris says, "Buyer beware. If you decide to invest in digital currencies, be sure to work with a reputable company — preferably one registered with the Treasury as an MSB [Money Services Business]."

You only put a reasonably small amount of your savings into digital currencies. Bitcoin, and especially other digital currencies, are still in the early days, and can be rather volatile. For example, if you've determined that you'll need $1 million to retire comfortably, and you'd still be on track to reach that target without the money you invest in digital currencies

In a nutshell, a bitcoin IRA can work as a small complement to an existing, well-rounded retirement portfolio, but it's important to understand the pros and cons of self-directed IRAs, as well as to have a basic knowledge of digital currencies and the risks involved with investing in them.

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