As cryptocurrency continues to come into its own as an investment, there are increasingly more options for how investors may go about investing in cryptocurrency and positioning their crypto holdings. And each option has its pros and cons. 

Crypto’s current march toward mainstream acceptance lends credence to the idea that it will be around for a while. There remain many unknowns. Possible regulation and the entrance of institutions into the market may or may not affect crypto’s performance. As an investment, it remains speculative, suitable for not more than a small percentage in most portfolios. 

There is a mania factor that drives at least a portion of the gains. People speculate that crypto is a game changer; they fear missing out on its inevitable ascent; they think it can do nothing but go up as it takes the world by storm. 

This was exactly what was said about the internet a little over 20 years ago. The internet turned out to be a game changer, and it created opportunity for many. There was also that whole bubble thing that happened, lest we forget that little episode. 

Crypto has a lot of potential. But not all cryptocurrencies will survive the coming changes. Investors need to be prepared for their investments to move strongly in either direction. That’s the nature of speculative investments. 

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Investment Purpose

The first consideration in how to hold any investment is its purpose. You wouldn’t put your emergency fund into an account that’s not easily accessible, and you wouldn’t generally put retirement accounts where they are in a fully taxable position unless you’ve exhausted your other options. Please don’t use crypto in your emergency fund — that’s just an example. 

Purpose is as important with crypto investments as it is with any other investment.

If you are willing to lock up any gains until retirement, then tax-deferred accounts offer some advantages. If you have big plans for your hoped-for windfall long before your retirement years come around, then a tax-deferred account is probably off the table. 

Even if you plan to actively trade your crypto investments, they are still speculative — and all speculative investments are long term. You may make short-term moves, but you don’t use them for short-term goals. It does not make financial sense to use a highly volatile investment for a near-term goal. 

Available Options for Investing in Cryptocurrency

Don’t expect the 401(k) floodgates to open quickly when you're deciding how to invest in cryptocurrency. Few 401(k)s allow investment into cryptocurrencies, and that’s not likely to change quickly. Some do, however — though in most of those cases, investors are limited to only a small percentage of their holdings.

This is done not only to protect the employee from losing all their retirement money, but also to protect the plan’s sponsors and administrators from lawsuits that follow when the previous thing happens. 

If you have a 401(k) from a prior employer, you may be able to roll the money into an IRA and gain access to crypto investments. 

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In the absence of crypto availability in your current work retirement plan, and if you don’t have another retirement plan, you still have options.

You can use an IRA, Roth IRA, or backdoor Roth IRA, if you want to make the trade-off of less availability of the funds for tax-deferred growth.

Taxation can be a significant issue for your crypto holdings. More so even, than for other investments. 

Tax Considerations When Investing in Cryptocurrency

Cryptocurrency is treated as property for tax purposes. You can own it in a qualified retirement plan or an IRA. The issue with qualified plans is that your plan’s sponsor or administrator may not allow it. 

When you own crypto in a non-qualified account, such as a typical brokerage account, you will have short-term capital gain for transactions when the asset was held for a year or less; you will have long-term capital gains when the asset was held for over a year. Long-term capital gains receive favorable tax treatment.

Short-term capital gains, however, do not. They are treated as ordinary income (after netting out losses). This puts them at the top of your brackets, you end up taxed on short-term gains at your highest marginal rate. 

The tax deferral of retirement accounts can prevent the pain of current taxation, but at a cost. Ultimately when you take your retirement distributions, post 59½, from a traditional 401(k) or IRA, the money is taxed as ordinary income. You give up the advantage of the favorable treatment of long-term gains that you would have in a non-qualified account.

The Roth accounts, whether a Roth 401(k) or Roth IRA do not have that downside of ordinary income taxation — retirement distributions, post 59½, are tax free from Roth accounts. 

And this is where we may throw some conventional wisdom out the window when it comes to deciding how to invest in cryptocurrency. 

Conventional wisdom would have us place our retirement assets in a hierarchy where those that receive the least favorable treatment in a non-qualified position are put into our tax-deferred accounts and those that receive favorable tax treatment in non-qualified accounts would remain outside of any tax sheltering account.

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The conventional wisdom would be to keep your crypto outside of any tax-deferred position, putting in less favorably treated assets instead. Of course, you would have to avoid trades that move your gains to short-term capital gains.

The conventional wisdom, however, seems to be being quickly broken down. A quick perusal online shows a number of recommendations to invest into crypto in a tax-deferred account so you can trade as you wish without tax implications. 

This ignores, however, the potential tax nightmare you could be building if you make a killing with your crypto. You could be giving up favorable treatment of long-term gains for unfavorable treatment of ordinary income from a traditional 401(k) or IRA.

Unless you use a Roth. That could be the holy grail of crypto accounts from a tax standpoint — with one major caveat. 

You have to be willing to forgo use of your gains, in most cases, until your retirement years. 

Using a Roth for your crypto eliminates the problem of unfavorable treatment if you make frequent or short-term trades. And it eliminates the problem of high taxation of distributions that come with large distributions from traditional retirement plans. That could be a win-win.

The Bottom Line on Investing in Cryptocurrency

No one knows what the future holds for cryptocurrencies. 

For investors who think they can make some gain and will want to spend it long before they get to retirement, a non-qualified account has some drawbacks, but is likely the most reasonable choice when choosing how to invest in cryptocurrency. 

For investors willing to leave their gains aside until retirement, a Roth account trades the deductibility of the contribution in the present for tax-free distributions later. If you make a killing with your crypto that is the ideal situation, a small cost now for a huge win later. After all, that’s why you’re going into crypto in the first place. You wouldn’t take all that risk if you expected modest gains. 

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Crypto does not defy the basic rules. Your choice as to the type of account is in large part dictated by what you plan to do with your future gains. But it does suggest you might do some things differently.

Where a traditional 401(k) or IRA is great for deferring taxes, you ultimately do pay the tax. Roth accounts have the potential, used correctly, to let you escape taxation on future gains entirely when you invest in cryptocurrency. And that matches well with where you think you might make the most money. 

Be careful out there. Sometimes not losing is a win. If you are, however, getting in the game, do so in the way that lets you keep the most, based on your timing and circumstances. 

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