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Crypto and Retirement Accounts—Can You?
By Mark R. Parthemer
Mark R. Parthemer is the Chief Wealth Strategist and Head of Florida at Glenmede Trust Co.
Crypto and Retirement Accounts—Can You?
Ashort decade ago, the cryptocurrency meteoroid launched and now is hurtling toward the trillions of dollars in retirement assets. Can clients embrace this digital asset and provide a soft landing in their retirement accounts?
Inspiring words from prolific author Mr. King, albeit encouraging writers. Clearly, he was not addressing investing in bitcoin, ethereum, or any cryptocurrency, but his framework may not be a bad starting point to analyze investing in cryptocurrency inside a retirement account.
The two major forms of managed retirement assets are IRAs and 401(k)s. So, let’s apply the “Can you?” filter to each of them. Although this article will explore some of the legal aspects of cryptocurrency in retirement accounts, it expresses no opinion as to the soundness or prudence of such investments. In other words, the “Should you?” question will go unanswered.
IRAs
According to the Investment Company Institute, by the end of 2019, there was over $11 trillion in IRA accounts in the United States. This represents over 34 percent of dedicated retirement assets. Of those assets, 64 percent are in equities or equity funds. ICI Research, May 2020. Further, households with an IRA have eight times the median financial assets of households without an IRA. The result is that households with IRAs have significantly more other investments, and for some IRA owners, cryptocurrencies may be a tempting allocation. So, “Can you?” That is, can an IRA hold cryptocurrencies? For clarity, we need to separate this question into two.
First, we need to explore if an IRA can be funded with cryptocurrency. The answer is yes, but not directly. By contrast, the general answer is no, with one exception.
This is because funding of an IRA is limited to cash. I.R.C. § 408(a)(1). This raises the question as to whether cryptocurrency is cash. Eight years ago, Treasury told us that, despite its name, for tax purposes, cryptocurrency is not currency, but property. IR Notice 201421. We thus have our general rule that one cannot contribute cryptocurrency into an IRA. But in § 408(a)(1), we also find the exception. It reads, “Except in the case of a rollover . . . no contribution will be accepted unless in cash.” Qualified rollovers may be in kind. I.R.C. § 408(d)(3). Therefore, if there is an existing allocation being rolled into a new IRA, then it is permitted as an original asset of the new IRA.
Second, may an IRA invest in cryptocurrency? The answer is yes, but let’s walk through the analysis. The I.R.C. defines what property can be owned in an IRA in the negative. That is, as we often find in the code, we are advised what is prohibited, and all else is permitted.
So, for an IRA, four types of property are prohibited: S corporation stock, life insurance contracts, personal use real estate, and collectibles. Id. § 408. The primary category of interest here is collectibles, which includes tangible personal property. Id. § 408(m)(2), (3). Coins generally are prohibited as a collectible, with the exception of certain precious metals. Those are certain gold, silver, and platinum coins; coins issued by any state; as well as gold, silver, platinum, and palladium bullion of certain fineness, but only if in the custody of a US trustee (US bank or financial institution). Id. § 408(m)(3)(A), (B).
A careful reading of that provision leads to the conclusion that cryptocurrency is not a qualified precious metal and not a collectible. Nor is it tangible personal property or any of the other forms of prohibited assets. Thus, cryptocurrency is not a prohibited asset and therefore can be an investment held in an IRA.
To review, then, cryptocurrencies are not barred from being in an IRA but cannot be used to fund an IRA, except via a rollover. Recall that an IRA may be managed or self-directed, and it may be difficult to find a manager with a tolerance for cryptocurrency (but there are some that absolutely will; just do an online search). Also, most large providers such as Schwab and Fidelity do not allow direct investment in cryptocurrency, so if the account is at an institution with this prohibition, only indirect investment currently is possible. Indirect exposure to cryptocurrency could be accomplished through an ETF or mutual fund.
401(k)s
As of June 30, 2021, there was over $7.3 trillion in 401(k)s. ICI Research, Oct. 11, 2021. Thus, such accounts constitute our second form of retirement assets. So, can you hold cryptocurrencies in these plans?
Unlike defined benefit plans, 401(k)s are employer-provided defined contribution plans. As such, they are funded with cash. Thereafter, the employee is entitled to select investments from a menu of employerapproved investment allocations. Unlike IRAs, however, there are no express statutory guidelines on qualifying assets. Under I.R.C. § 401(a)(35) (D), an investment menu need only have three options (employer securities are ignored for this criterion), “each of which is diversified and has materially different risk and return characteristics.” I.R.C. § 401(a)(35)(D). The answer to the “Can you?” question depends on the other options, but it is certainly possible.
Earlier this year, a large plan administrator hosting over 23,000 401(k) plans with over 20 million participants announced that employers will be able add a cryptocurrency allocation. Initially, this authority will be limited to bitcoin and maxed out at a 20% allocation (employers will have the ability to set a lower allocation cap). A company representative indicated an expectation to expand to other digital assets in the near future. This confirms the ability to permit an employer to include an allocation to cryptocurrencies, but is doing so without liability?
Employer Liability Considerations
There are two components to understanding potential employer liability surrounding cryptocurrencies in 401(k) plans. First, if an employee selects an allocation and it drops in value, can the employee sue the employer? One would not expect that the employer be a guarantor of investment success, and that is correct. In fact, ERISA § 404(c) limits fiduciary liability for individual investment decisions. Specifically, if a participant exercises control over the assets in his account, then no person who otherwise is a fiduciary (this includes the employer) will be liable for any loss, or by reason of any breach, that results from such exercise of control. Thus, there is no cause of action against the employer for investment losses.
Second, and in contrast, the employer does have a fiduciary duty to prudently select and monitor investment alternatives. Specifically, ERISA § 404(a)(1)(B) requires plan fiduciaries to act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” So, adding an investment allocation to the menu is something for which the employer may be held accountable. Would adding cryptocurrency investments be prudent? Would not adding one be prudent? Those are certainly questions of fact and go to the “Should you?” question, which, as promised, will go unanswered. It is, however, worth mentioning that representatives of the Department of Labor have expressed hesitation.
The Labor Department regulates company-sponsored retirement plans. Ali Khawar, acting assistant secretary of the Employee Benefits Security Administration, said in an interview with The Wall Street Journal that he views cryptocurrency as speculative and expressed concern over permitting cryptocurrency allocations. Ann Tergesen, Bitcoin in Your 401(k): Is That a Good Idea?, Wall St. J. (Apr. 30, 2022), https://on.wsj. com/3MEFJez.
It should be noted that the DOL has recently established agency guidance to the effect that companies offering cryptocurrencies in their retirement plans should expect to be investigated. This is based on factors including the market’s volatility and the lack of broadly accepted methodologies investors can rely on to evaluate prices. As of the submission of this article, a plan administrator based out of San Francisco with 500 401(k) plans, 150 of which do have a cryptocurrency option, has filed suit in the U.S. district court in Washington, D.C. This plan administrator permits employers to adopt an option for participants to invest up to 5 percent in bitcoin, ether, Litecoin, and other cryptocurrencies. See Wall St. J., June 3, 2022, p. B1.
Other Concerns
Beyond prudence and the above analysis regarding legality, other factors to be considered include:
1. Cybersecurity (most plan sponsors don’t have blockchain expertise);
2. Indicia of ownership, especially for cryptocurrencies not based or held in the US and the potential for future regulation from SEC or DOL;
3. Fees (such as custodial and exchange), which tend to be higher than for most mutual funds and ETFs;
4. Tripled increase in S&P 500 correlation (up to .78) over the last few years, diminishing reality of perceived diversification; and
5. Bankruptcy of an exchange. Cryptocurrency is not necessarily segregated, so there is the potential that bankruptcy of an exchange entity might convert “owners” into general unsecured creditors. The SEC now requires a disclosure that alerts to the fact that crypto assets are not insured or guaranteed by any government or government agency and the legal risks in the occurrence of a financial event such as bankruptcy. Staff Acct. Bull. No. 121, 17 C.F.R. § 211. One publicly traded cryptocurrency exchange, Coinbase, in its May 10, 2022 10-Q, provided in part:
[B]ecause custodially held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors.
This statement, combined with a meaningful loss of market value of over 80 percent, led to public reaction. In response, on June 1, 2022, Coinbase’s chief legal officer released a press statement assuring its customers that based on Coinbase’s business practices, customer assets were not comingled or at risk. The point is not whether in specific there is a risk to this company’s customers but that there is an evolving area with legal uncertainty surrounding numerous issues that perhaps should factor into a participant’s or an employer’s decision making.
Conclusion So, the ultimate answer as to the legality of cryptocurrency in the major two forms of retirement accounts is clear. On the other hand, perhaps like the proverbial understanding of beauty, prudence may be in the eye of the beholder.
This article is provided solely for informational purposes and is not intended to provide financial, investment, tax, legal, or other advice. It contains information and opinions that may change after the date of publication. The author takes sole responsibility for the views expressed herein, and these views do not necessarily reflect the views of the author’s employer or any other organization, group, or individual. Information obtained from third-party sources is assumed to be reliable and has not been verified. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Readers should consult with their own financial, tax, legal, or other advisors to seek advice on their individual circumstances.
Published in Probate & Property, Volume 36, No 5 © 2022 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
Probate & Property September/October 2022
