LAST REVIEWED Apr 08 2019 12 MIN READ
By Damian Davila
One of the most talked about investment opportunities of 2017 was bitcoin – a digital currency issued based on computer algorithms instead of being issued by banks or governments. If you had purchased one bitcoin back on January 2, 2017, you would have paid $989.13. That same bitcoin would have been worth about $16,496.80 on December 21, 2017, providing you a handsome return of 1,567.81%!
To put things in perspective, an investment in the Vanguard S&P 500 index fund (VFINX) would have yielded a 15.39% return over the same period. But while it seems like an incredible investment in comparison, is bitcoin an appropriate way to save for retirement?
What is bitcoin?
Unlike other currencies, bitcoin has no physical form. You keep bitcoins using a public key, which is a long string of numbers and letters linked through the mathematical encryption algorithm that was used to create bitcoins. Think of the public key as a bank account number that you use to deposit, withdraw, and transfer money.
Coins are created by miners: independent individuals who solve a computationally difficult puzzle to discover a new block, which is added to a blockchain, and receive a reward of a few bitcoins. A block is the permanent record of unique Bitcoin transactions: just like a page in ledger. Each time a block is discovered and created, it gives way to the next block in the blockchain. So, a blockchain is set of permanent records that can never be altered. As you can see, the entire bitcoin system is backed up by the trust of those mathematical operations rather than the trust that a financial institution or government is able to meet its financial obligations.
Because the production cost of every new bitcoin rises – in terms of the time and energy it takes to create it – and there is a limit to the total amount of available bitcoins (21 million, which we are estimated to reach by 2040), the currency was designed to naturally appreciate in value over time.
Why is the market value of bitcoin so high?
Independence from traditional financial systems
In many instances, individuals can do transactions with lower fees and faster completion rates. Let’s imagine that you wanted to buy Panama hats straight from a manufacturer in Ecuador. If you were to send payment through traditional channels, such as a bank transfer or wire, it would cost you a fee and take up to a couple of days to clear. The manufacturer may also depend on the hours of operation of a financial institution to collect payment. On the other hand, bitcoin allows both of you to complete a transaction through a computer or mobile phone, often within a couple of minutes, at any time of day.
More and more merchants accept bitcoins
Early on, bitcoin was only used by a small number of niche companies and individual early adopters. Now, major U.S. companies have also jumped on the bitcoin bandwagon. Expedia, Microsoft, and Overstock are some of the retailers accepting bitcoin as form of payment as of November 2017. The number keeps growing as several companies at the local level jump on board, such as the San Jose Earthquakes soccer team in California and Helen’s Pizza in New Jersey.
Opportunity for diversification
With a current market cap of over $137 billion, bitcoin provides an opportunity for additional diversification to investors. This virtual currency appears to operate on different fundamentals than equities and fixed income securities. Additionally, the explosive growth in bitcoin has sparked the birth of several other cryptocurrencies, including Ethereum, Ripple, Monero, and Litecoin. The capitalization of the cryptocurrency market as a whole was estimated at over $263 billion as November 24, 2017.
Potential tax advantages
As with other technologies, government regulations have been slow to catch up. Depending on how much bitcoin you own and what exchange you use, it may be hard for third parties to trace transactions back to an individual. This means that many bitcoin owners didn’t pay taxes for many years. It wasn’t until March 2014 that the IRS provided official guidance as to how treat bitcoin for U.S. federal tax purposes. Since the IRS considers bitcoin and other types of virtual currency as property for tax purposes, there are some tax breaks that you can obtain from doing transactions with bitcoin.
For a deeper dive, here’s a summary of tax consequences of using bitcoin.
So, is using bitcoin for your 401(k) a good idea?
The general stance of Human Interest is that bitcoin isn’t a suitable recommendation for retirement accounts.
High price volatility
While we’ve covered the upside of bitcoin, we should be should clear on the potential risks. On August 31, 2017, one bitcoin traded for $4,912 and just a few days later on September 12th, one bitcoin traded for $3,961. Could you stomach a 19% loss on your entire nest egg in under two weeks? Following the intraday market price of bitcoin can make even the most risk-averse investors feel sick.
Margin for user error
At the end of the day, your bitcoin wallet is just a string of numbers and letters. If you lose access to that code, your investment goes up in smoke. From the man that threw away a hard drive containing the wallet number to 1,400 bitcoins to the other man that lost $30,000 in bitcoin for forgetting his PIN, there are many scary instances in which holders of bitcoin have lost their coins forever.
There are many ways in which a bitcoin transaction can go wrong. For example, if you were to send bitcoins to the address of another cryptocurrency, such as Litecoin or Dogecoin, then your coins will be most likely lost. To undo such an error, most exchanges require a transaction minimum (Bittrex sets a $5,000 minimum) and will charge you a hefty fee for the recovery.
Bitcoin rules vary by state
Certain states implement legislation that can make certain companies to stop serving residents in that state. In 2015, New York’s BitLicense regulatory framework scared away bitcoin exchanges Kraken and Bitfinex. Two years later, Hawaii legislators created regulatory policies that required exchanges to hold cash reserves and the largest U.S.-based exchange, Coinbase, decide to cease operations.
Such regulatory changes can have serious consequences on a bitcoin investment, such as liquidity issues, smaller choices for exchanges, and variable costs.
I understand the risks involved. Still, how can I hold some bitcoin on my retirement account?
As of November 2017, there are only two options for holding bitcoin on your retirement account.
There are 3 conditions that would have to be met for you to be able to hold bitcoin on your employer-sponsored 401(k):
Your employer selected ERISA 3(21) fiduciary for the plan and the paid service provider of your plan could recommend a fund that provides exposure to bitcoin
The bitcoin-related fund was formally added to the plan’s fund lineup
You’re able to select that fund
Currently, the only fund available to get exposure to bitcoin is the Bitcoin Investment Trust (GBTC). While there are many exchange-traded funds (ETFs), mutual funds and even hedge funds claiming to hold bitcoin, the reality is that most of them do so by buying shares of the Bitcoin Investment Trust.
Keep in mind the annual expense ratio of the Bitcoin Investment Trust is a whopping 2.0%. To put things in perspective, the annual expense ratio of Vanguard S&P 500 index fund (investor class) is just 0.14%.
Using a self-directed IRA, you can invest in a wide variety of financial assets, including bitcoin. However, there are several costs to consider, including setup fees ranging from $600 to $10,000, depending on your unique financial situation. And there are recurring annual fees after that.
Another way is to use a third-party providers, such as BitcoinIRA, that allows you to hold bitcoin in an IRA. But, you still have to pay a hefty fee. BitcoinIRA charges a one-time upfront fee of 15% on deposits of $15,000–$100,000; 13% on $100,000–$200,000 placements, and 11% on those $200,000 and above.
The Bottom Line: Tread cautiously with bitcoin when saving for retirement
Saving for retirement with bitcoin is possible, but it isn’t for everybody. Investors with a high aversion to risk should steer clear from bitcoin. If your retirement account were to provide you the opportunity to diversity with bitcoin, you should limit your allocation according to your investment strategy, tolerance to risk, set of applicable state rules, and time away from retirement age. A useful benchmark is the standard rule of 5% of allocation when selecting individual stock securities. While this rule isn’t exact science, it provides a starting point to discuss allocation.
Also, make sure to map out all applicable costs involved in a bitcoin investment through a retirement account, particularly with an IRA. Make sure to contact your financial adviser and plan provider before making investments in bitcoin and any other cryptocurrencies.
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.