2017 is likely to be considered the watershed year for cryptocurrencies, which have become an exceedingly hot investment asset class. Since the creation of Bitcoin in 2009 it has largely been an obscure interest of an exclusively tech-savvy audience. This year has changed the game, with a series of regulatory acknowledgements and broader implementations of the underlying blockchain technology.
Prices of Bitcoin, Etherium, Litecoin and a host of other virtual currencies have soared as a result. Bitcoin has exhibited a 396% gain in value from a January 1, 2017 price of $997 to a peak of $4950 on September 1st. Etherium, which is both a virtual coin and a systems platform designed to operate on “smart contracts” has gone from $8.18 to $379.50 in the same time period. That is an amazing 4539% gain in value in just 9 months.
As more governments, central banks, financial institutions and business look at ways to work with virtual currencies and the potential of blockchain technology, the question is not if, but rather when cryptocurrencies will become mainstream.
Many futurists are predicting that the blockchain technology upon which cryptocurrencies are based will bring about economic changes on the same level of magnitude as the internet and world wide web did 20 years ago. So, if we are in the cryptocurrency equivalent of AOL and dial-up connections today, what does “broadband” blockchain look like in 5, 10, or 20 years? Projects are under way around the globe to move all kinds of paperwork-intensive transaction-based businesses such as container shipping and property title recording onto distributed and secure blockchain networks.
Your IRA or Solo 401(k) Can Invest in Bitcoin
In 2014, the IRS issued Virtual Currency Guidance in notice 2014-21. Bitcoin is specifically named as part of a class of virtual currencies deemed to have an equivalent value in real currency. As such, and because these virtual currencies can be purchased for or exchanged with US Dollars, they are an acceptable asset class for IRA and 401(k) plans to invest in.
Ways to Invest
As of this writing, there are effectively 4 ways to invest in virtual currencies:
- Direct ownership of virtual currency “Coins”
- Privately held virtual currency “Funds”
- Coin Mining operations / contracts
- Initial Coin Offerings (ICO’s)
Let’s take a look at each of these options, only one of which really makes any sense for retirement investors.
Investing in Virtual Coins – The way to go with an IRA
This is probably the most common approach. Your IRA LLC or Solo 401(k) can establish an account with an exchange that trades virtual currencies. The IRA can then contribute dollars to an account with the exchange and engage in trading activities. From a mechanics perspective, this is very similar to foreign exchange trading between, say US Dollars and Euros, Yen, or Yuan. There are many strategies that can be deployed for long term buy and hold, monthly purchase cost-averaging, or short-term fluctuation-based trades. Some exchanges even allow for the use of margin or put/call techniques, though this can get tricky in the IRA/401k space where such debt-instruments must be non-recourse and can create exposure to UDFI taxation.
When trades are executed on an exchange, the acquired coins are then stored in a virtual “wallet” that is essentially a distinct URL with an encryption key. There are wallets held by the various exchanges, 3rd party cloud wallet services with enhanced security features and even offline physical wallets in the form of a portable hard drive or USB stick.
Selecting one or more exchanges to work with and a type of wallet can be complex. There are many exchanges to choose from, with some of the more common available to US investors being Coinbase, and Kraken. As you research exchanges, you will want to ensure they can serve you. Not all operate in the US and there are a few that operate in slightly less than all 50 states for regulatory reasons. You will also want to understand what registration requirements are necessary to achieve a suitable “tier” for the type of investing you wish to do. It can take a good bit of documentation as well as some trading history to be able to work with a substantial amount of US dollar equivalency. Some exchanges handle a small set of more established coins such as Bitcoin, Etherium, Litecoin and Ripple, while others provide access to newer specialty coins like Tron and Waltoncoin.
Investing in Coin Mining
In the case of Bitcoin and many other virtual currencies are created via a process known as “mining”. This is a process whereby transactions are verified and added to the public ledger known as the block chain. By dedicating computer resources to verify and bundle coin transactions into a new block and then solving a math problem as “proof of work” a miner earns new coins.
There are various ways to participate in mining, from acquiring specialized computer hardware connected to the internet to purchasing shares of a mining company.
Unfortunately, mining activities are not well suited as investments for an IRA or Solo 401(k) plan. The issue is that in the IRS 2014-21 notice, mining is identified as a trade or business activity. As such, engaging in such investments will expose a retirement plan investor to UBIT taxation and corresponding trust tax rates potentially as high as 39.6% on the gains.
While Coin mining reasonably secure, it is an activity better suited for non-retirement funds where tax rates will likely be lower.
Investing in Initial Coin Offerings
Initial Coin Offerings are effectively crowdfunding mechanisms deployed in the virtual currency space. Entrepreneurs planning a new venture associated with a virtual currency put forth a business plan and solicit investors to participate via a purchase of a newly issued coin. The hope of investors in such ventures is that the coin in question will become worth more if the project achieves success.
There have been several notable successes in the ICO space, most notably the virtual currency Etherium and its corresponding block chain platform for executing smart contracts. In 2014 the Etherium project raised $18 million USD equivalent in Bitcoin resulting in an initial coin price of $0.40 per Ether. The project went live in 2015 and the value of Ether went as high as $14 in 2016. Ether is currently trading at approximately $300 per coin.
Likewise, there have been some abject failures and outright fraud in the ICO space. This is an unregulated domain and not subject to the same reporting requirements that a US based crowd funding venture needs to comply with. So, while ICO’s may be a disruptive way to promote innovation, they are also highly speculative and risky, with no regulatory backstop or means to pursue remedy in the event of fraud.
In September 2017, the Chinese government officially banned ICO’s and prohibited exchange and banking services tied to such ventures. ICO’s are still available on non-Chinese platforms.
Such investments should be approached with great caution or avoided altogether.
Investing in Virtual Currency “Funds”
Several industry players such as the Winklevoss twins have attempted to gain regulatory approval for publicly traded virtual currency ETFs. Such a request was denied by the SEC in the spring of 2017 and to date no venture has had success at this level.
There are various private funds promoted via channels such as the internet. This is an unregulated space and something that should be approached with extreme caution. The SEC has identified and prosecuted Ponzi scheme operators and other fraudulent actors in this space.
We recommend against such investments.
As Always… Do Your Homework
Virtual currencies are a rapidly developing space in the investment world. There are many unsolved regulatory questions and limited oversight relative to more conventional asset classes. That said, there is a huge amount of potential and for investors with the ability to gauge and accept risk, there may be continuing opportunities for significant returns. If you choose to pursue a strategy of investing in cryptocurrencies such as Bitcoin or Etherium, take the time to learn about the tools necessary to get your IRA or 401(k) dollars into the space and secure your holdings with a robust wallet. Due to the high levels of uncertainty, volatility, and risk, we suggest you not invest any capital you are not willing to lose.