Ever since they exploded into the public's consciousness in 2009, cryptocurrencies have remained a point of contention and uncertainty among financial experts. Regardless, people are spending millions on digital currencies and online artifacts like NFTs. Some are even trying to invest in cryptocurrencies as a way to plan for their retirement. But how does today's cryptocurrency market compare to more proven investment vehicles, such as Roth IRAs?
- Once considered a fad, cryptocurrencies continue to grow and evolve into other products, such as NFTs.
- Federal regulations have not fully caught up with cryptocurrencies.
- Roth IRAs are a regulated and proven method of saving for retirement in a tax-advantaged manner.
How Cryptocurrency Works
Cryptocurrency may sound like a futuristic innovation in a science-fiction novel, but it's a real-world concept. At its core, cryptocurrency is a digital currency that's secured through the use of one-way cryptography. All cryptocurrency shows up on a digital ledger known as a blockchain, which proponents say is impossible to counterfeit or hack.
How a Cryptocurrency IRA Works
In addition to buying and selling individual cryptocurrencies out on the market, some IRA providers are looking to infuse the technology into retirement savings. Cryptocurrency IRAs—or Bitcoin IRAs—are a type of self-directed IRA (SDIRA) that lets you buy and sell cryptocurrencies in a tax-advantaged retirement account. Though only currently offered by a few financial institutions in the U.S., cryptocurrency IRAs allow an individual to maintain more traditional retirement accounts while operating a separate account that invests in digital currencies like Bitcoin and Ethereum.
Advantages of Cryptocurrency Investing
Though there are well-documented risks associated with cryptocurrency investing, there are some potentially major upsides to the practice as well. The following are some of the potential benefits you can get from investing in crypto.
- Potential for large—albeit risky—gains. Cryptocurrencies are extremely volatile. If you're able to buy low and sell high, the peaks of those highs can be massive.
- Peer-to-peer transactions. Unlike most other investment options, there's no need for a bank or financial institution to act as a middleman during a transaction. This can lead to a clearer understanding of the terms of the transaction and create a situation in which there's more accountability between the parties.
- 24/7 trades. The Internet is always on. As a result, so is cryptocurrency trading. Rather than having to wait for the New York Stock Exchange, Nasdaq, or other trading platforms, you can buy, sell, and trade cryptocurrencies whenever you want.
Disadvantages of Cryptocurrency Investing
Though there may be some upsides to investing in cryptocurrency, there are just as many potential drawbacks. Investing in something you don't fully understand could bring you some soaring highs or suddenly go up in smoke.
- More speculation than investment. It's hard to invest in something for which it's difficult to assign value. "One cannot invest in the wide array of cryptocurrencies. One can only speculate," says Robert R. Johnson, a chartered financial analyst and professor of finance at Creighton University. The tools of traditional finance cannot determine the intrinsic value of Bitcoin or any cryptocurrency, according to Johnson.
- Poor at scalability. Given its decentralized nature, it's difficult to imagine a time when it could compete against established forms of currency.
- Extreme volatility. One of the potentially good things about cryptocurrency trading is also a major drawback. Prices fluctuate so wildly that it's hard to ensure you'll get the most bang for your investment buck.
Digital currencies aren't the only thing investors are trading. Non-fungible tokens (NFTs) have become massively popular in recent months, with unique digital images fetching large amounts of money. Like other data linked to cryptocurrency, these digital pieces of artwork are extremely limited with highly volatile market values.
How a Roth IRA Works
A Roth IRA is a type of individual retirement account (IRA) that gives someone the ability to make tax-free withdrawals in retirement. Every contribution made to the Roth IRA is taxed upfront. As long as you're at least 59½ years old and the money you want to withdraw was deposited at least five years earlier, that money is yours to do what you wish with it, tax- and penalty-free.
Benefits of a Roth IRA
As an already trusted method of preparing you for retirement, there are plenty of reasons to seek out a Roth IRA in preparation for a post-work life.
- Favorable taxes. The biggest draw for a Roth IRA is the fact that withdrawals are tax-free after a certain age and as long as the money has been in the account for five years. It's true you have to pay your taxes upfront, but you'll be doing so while you're likely in a lower tax bracket.
- No required minimum distributions. Though some retirement accounts have minimum distributions after you reach a certain age, Roth IRAs don't have such a restriction. As such, you can continue earning interest on your funds even after you retire.
- Tax diversity. When combined with other retirement accounts, you can diversify how your taxes are calculated on the funds you pull out of your account. For instance, a traditional IRA has taxes charged on the distribution, while Roth IRAs offer tax- and penalty-free distribution.
Downsides of a Roth IRA
The following are some of the disadvantages of opening and maintaining a Roth IRA.
- You must prepay taxes. When you start your Roth IRA, you're usually in a lower tax bracket. That means you won't have to pay much into it to start, but that also means you're taking home less money now.
- Low ceilings on how much you can contribute. Your income has a direct impact on how much money you can contribute to your Roth IRA. You're limited to $6,000 for 2022 ($6,500 for 2023), or $7,000 if you're more than 50 years old ($7,500 for 2023).
- Your income can have an impact on how much you can contribute. Roth IRAs and how much you're able to put into them are dictated by how much money you make. The measure is based on your modified adjusted gross income (MAGI) and whether you're filing your taxes as a single individual or jointly with your spouse.
How Is Digital Currency Treated for Income Tax Purposes?
According to the IRS, all digital currency is considered property. As such, general tax rules that apply to property transactions would apply to virtual currency.
Are There Other Ways to Invest in Cryptocurrencies?
Yes. There are multiple pathways to investing in cryptocurrencies if you don't want to hitch your retirement funds to such a volatile prospect. Some financial institutions offer crypto futures trading, while others offer Bitcoin trusts and blockchain ETFs.
The Bottom Line
If you're investing in cryptocurrency as a way to prepare for the future, be sure to keep in mind the risks this will involve. The market surrounding cryptocurrency fluctuates so rapidly it's hard to get a grip on the worth of digital assets. Still, an option like a cryptocurrency IRA could pave the way for a safer retirement planning method. Be aware that more traditional methods, such as Roth IRAs and 401(k)s, are viable options that you can rely on while dipping your toes into the world of cryptocurrency investment.
Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.