By: Phil Gaudiano, CPA
As alternative asset classes move toward greater acceptance, many people have become interested in including non-traditional investments in their retirement planning. Self-directed IRAs (sdIRAs)have been available since the passage of ERISA in 1974, but recently there seems to be much more interest in them. This is undoubtedly the result of the recent crypto boom and more investors looking to hold crypto assets in tax-advantaged accounts. For anyone looking to use a sdIRA, this will serve as a quick guide on the principles involved, with an eye toward the specific circumstances of crypto investors.
How is a sdIRA different from a traditional IRA or roth IRA?
It really isn’t. Under §408 of the Internal Revenue Code, there is no distinction made between self-directed and other IRAs. Functionally, a sdIRA operates much the same as a traditional (or roth) IRA, with the same contribution limits, withdrawal restrictions, and income limitations.
The biggest difference is in the type of assets you can own with a sdIRA, like:
- Real estate
- operational or raw land
- Precious metals
- gold, silver, platinum
- LLCs & Corporations
- Crypto
Since most of the IRAs available are from major brokerages (Fidelity, Schwab, Vanguard, etc.), it is a common misconception that you are only allowed to hold traditional financial assets (stocks and bonds) in an IRA. This isn’t true, but custodians of self-directed accounts are not allowed to advise which investments you choose to fund with sdIRA funds, so most major brokerages don’t offer self-directed options. You will need to work with a third-party custodian or trustee to open a self-directed IRA.
Traditional vs Roth Treatment
Self-directed IRAs have all of the normal features of other qualified retirement plans. The key decision you need to make when setting it up is when to pay the taxes. With traditional IRAs, money put in during the year (subject to annual limits) is deductible on your current tax return, and you pay tax on distributions from the IRA at ordinary income rates in the future. With a roth IRA, there is no upfront tax deduction — money goes into the plan on an after-tax basis — but distributions are generally tax-free in retirement.
There are other differences between traditional and roth plans, including income limits, required minimum distributions (RMDs), and early withdrawal penalties & taxes that might make you favor one type over the other, but most people make the decision based on the timing of taxes alone.
Prohibited Transactions (Self-dealing & Borrowing)
The prohibited transaction rules in IRC §408 and §4975 apply to all qualified retirement plans, not just self-directed plans. Still, they become important to note in any discussion around self-directed plans because of the level of control an investor can have over the funds in his or her account. Generally, these rules prohibit any transaction involving a “disqualified person” — a term we can broadly define as any family member or service provider of the IRA account holder.
Disqualified Persons
If an IRA account holder engages in a prohibited transaction, the entire account balance of the IRA will be deemed to have been distributed to you in the year in which the prohibited transaction took place. You would be liable for all taxes & penalties on the distribution.
Likewise, if an IRA account holder pledges the IRA account as collateral for a loan, then the collateral amount is deemed to be distributed to the account holder. As in the prohibited transaction example above, you would be liable for taxes & penalties.
Special Considerations for Crypto Investors
In general, a sdIRA is an effective way to buy and hold crypto assets as part of your retirement strategy. However, there are a few considerations that most crypto investors should keep in mind:
Unrelated Business Income Tax — Commonly called by the acronym UBIT, this is tax owed on profits of an active business owned by a tax-exempt entity (i.e. an IRA). While common types of investment income are exempt from UBIT under IRC §512, including capital gains, interest, dividends, and certain rents, common types of crypto income are not mentioned.
Generally, for different types of crypto income, we apply the descriptor of the type of traditional income that it most closely resembles. For example, staking income is primarily regarded as traditional interest income. However, this logic may not necessarily hold up in the context of UBIT.
When we discuss general income taxes, the distinction between interest income and ordinary income is rather unimportant. Both types of income are taxed at ordinary rates. So, if the IRS decides to classify staking income as ordinary income at some point in the future, nothing will change on the 1040s you’ve filed. However, that change in classification could mean that staking income is subject to UBIT.
Other types of crypto income will also be subject to UBIT, including mining and income earned by many DeFi protocols. There are workarounds here involving the use of blocker corporations to lessen the blow of UBIT, which are advanced strategies. The general rule with crypto held in an IRA is that anything beyond general trading (i.e. buying and selling on an exchange) could be considered unrelated business income and subject to UBIT.
Collectibles — Under IRC §408(m), investments in collectibles are treated as distributions of IRA funds. This is essentially the same treatment we discussed above for prohibited transactions. The issue here, as it relates to crypto, is the definition of the term “collectible” and whether the term applies to NFTs.
There has been much talk in tax circles about whether the broad definition of a collectible as “any work of art” would capture NFTs, or whether the catch-all definition a few lines later of “any other tangible personal property” that the Treasury Secretary deems as a collectible would be too narrow, since NFTs are not tangible. At present, we don’t know.
Certainly, any of the art-based NFTs would fall under collectibles — and the majority of NFTs we see currently are art-based — but as the space evolves and more things are tokenized aside from art, this may change. However, due to the uncertainty around whether NFTs are collectibles, as defined by the Tax Code, you would do well to avoid holding NFTs in a sdIRA for now.
Conclusion
There is far more to discuss around self-directed retirement accounts than what was mentioned in this piece, but it should serve as a good primer for those who are curious about how they work. The ability to put crypto and other alternative assets in tax-advantaged accounts is appealing to risk-on investors. Still, they should be mindful of the limits on certain activities that may invalidate the tax advantages of IRAs, especially given the uncertainty of crypto’s broader place in the Tax Code.