Why Can’t I Hold the Keys to My Crypto IRA? Crypto Keys Explained

You might have heard it before: “Not your keys, not your crypto.” It’s a popular phrase among crypto diehards, and one we get a lot of questions about.

But what does it mean? And how does it apply to cryptocurrency held in an IRA?

To make sense of it all, we’re taking a deep dive into a number of frequently asked questions, including:

• How does the blockchain work?
• What are crypto keys?
• What is a crypto wallet?
• What do keys and wallets have to do with my crypto IRA?
• Why can’t I hold the keys to my crypto IRA?

So stick around to learn about crypto keys, wallets, custody, and what it means for you.

Blockchain Basics

Before we discuss how crypto wallets work or the role of public and private keys, it’s essential you have a baseline understanding of how blockchains work.

A blockchain is an immutable (meaning unalterable) ledger of transactions that is grouped into blocks and linked together in — you guessed it! — a chain.

Typically, as with Bitcoin, this ledger is decentralized, meaning it’s not governed by a central authority. Rather, nodes (basically, computers that run a cryptocurrency’s software) keep independent copies of all previous blocks.

When a new transaction occurs, it’s transmitted to these nodes, which listen for new transactions and group them into blocks. To prevent fraud, a node (also called a miner) must solve a complicated mathematical equation proving it did the work to complete a block. (This is where the term “proof of work” comes from.)

The first miner to solve the equation receives a reward for helping to build the blockchain. For example, Bitcoin miners receive BTC as a reward. Meanwhile, the other nodes validate the work against their copy of the blockchain.

If a majority of nodes see a newly created block as valid, the chain continues. But if a majority see a new block as invalid, the blockchain could split (called a fork). Gaming the system isn’t that easy, though. Because the network defers to the longest blockchain, maintaining a fraudulent record would require an unscrupulous miner to perpetually beat all other miners to completing blocks-a mathematical near-impossibility. Aside from hard forks, which are a discussion for another day, the problem will work itself out in short order. The majority of validators will reject the bad block and continue building on the original blockchain, rendering the rogue chain effectively useless.

So what does this have to do with crypto keys? A lot, actually.

What Are Crypto Keys?

Every time BTC is sent or received, it’s recorded on the blockchain. However, Bitcoin’s creator Satoshi Nakomoto designed the cryptocurrency using public-private key cryptography so that users could transact anonymously.

In this system, users have a public key and a private key, both of which are required to access your crypto. Essentially, a public key is used to encrypt a message and a private key unencrypted it.

Think of your public key as a post office box that only you can access, and your private key as the key to that mailbox. Just as anyone can send a letter to your post office box, anyone can send Bitcoin to your public key. When crypto is sent to you, it’s recorded on the blockchain as a transaction between the sender’s public key and your public key. But to access (or unencrypt) that balance-say, to send your BTC to a friend-you need your private key. Without it your crypto is stuck.

Given their complexity — each private key is a randomly generated 256-bit number that corresponds with your public key — it would be immensely difficult for even the most sophisticated of computers to hack. In fact, there are said to be fewer grains of sand on earth than private key combinations.

How does anyone remember their private key, then? To make it , many private keys, such as those associated with Bitcoin, are represented in a (relatively) shorter, hexadecimal format . For example, a hexadecimal private key might be:*

D7565E67B5C98CD1FA0B7569875543D9109874563AD16F02BA54CF089BD17168

Unfortunately, that’s still far from convenient. Imagine checking out at the grocery store and needing to enter your private key instead of your 4-digit PIN number. (No, thanks.) This is where crypto wallets come in.

Example solely for the purpose of illustration. You should not use this as a private key.

What Is a Crypto Wallet?

Essentially, a crypto wallet is just a place to securely store your keys. But as you can probably imagine, there are a handful of wallet types to choose from, each with its pros and cons.

A crypto wallet could be as simple as a piece of paper with your private keys on it (hopefully stored in a safe), an online wallet, or even hardware-based-think a thumb drive (for example, the popular Nano Ledger).

Offline Crypto Wallets

Also called “cold wallets,” these range from hardware devices to purely analog solutions, making them popular for long-term storage. However, this also means less convenience when you need to access your crypto.

A private key written on a piece of paper is inherently safe from hackers, but could get lost, deteriorate, or fall into the wrong hands. Entering a private key any time (or where) you need access to your coins is also not very convenient.

A hardware wallet allows you to make crypto transactions, but needs to be connected to a computer in order to send or access your crypto. This, to many, means greater security. However, hardware wallets can stop working or be lost.

Take the British IT engineer who in 2013 accidentally threw away a hard drive that held his private keys to 7,500 Bitcoins — worth nearly $155 million as of October 27, 2022. (In case you’re wondering, he’s still looking for that hard drive, and we can’t blame him.)

Online Crypto Wallets

Often called “hot wallets,” app- or software-based online wallets tend to be more convenient, allowing access wherever you are. There’s an obvious disadvantage, though: If someone is able to get into your account, they can access your crypto.

There’s also a tremendous range of online wallets, from self-custodial wallets (Metamask and Coinbase Wallet) to custodial web-based exchange wallets (a standard Coinbase account).

Many crypto proponents, however, would argue that the bank-like functionality provided by custodial wallets goes against the founding principles of crypto. According to CoinDesk, “When a user outsources wallet custody to a business, they are essentially outsourcing their private keys to that institution.”

Ultimately, what’s right for you depends on your preferences.

Custodial and Non-Custodial Wallets

Often, exchanges offer both custodial and self-custodial wallets to accommodate various user’s needs and comfort level. With custodial wallets, when you want to buy, sell, send, or withdraw crypto, you effectively authorize the exchange to carry out those actions on your behalf.

An example of an exchange that offers both custodial and self-custodial wallets is Coinbase.

Think of a Coinbase account like a traditional brokerage account. You can buy, sell, and trade coins and tokens. But you can’t send crypto to an individual wallet, which may or may not matter to you. And you don’t hold the keys.

Coinbase Wallet, on the other hand, is a self-custodial wallet, meaning you hold your private keys in your web or mobile browser. Not only does a self-custodial wallet give you access to more digital assets. You can also send and receive crypto from specific wallets, which is essential if you intend to make purchases using your crypto.

Keys, Custody, and Crypto IRAs

Now that we have a better understanding of crypto keys and wallets, it’s probably pretty clear what people mean when they say, “Not your keys, not your crypto.”

If you don’t hold your keys (their words, not ours), someone — be it an exchange, a government, or hacker — could gain access to your crypto. On the flip side, you could easily lose your private keys forever, and many people have.

But what you really want to know is what “Not your keys, not your crypto” means in the context of crypto IRAs.

Why Hold Crypto in an IRA?

The intention behind Bitcoin was to anonymously transact with people around the globe using a currency not subject to the controls of central banks. To date, though, relatively few people and businesses use crypto for day-to-day transactions. (However, according to a recent Deloitte survey, that’s changing.)

Instead, Bitcoin has come to be seen as both a store of value and an investment. Owing to the tremendous gains Bitcoin and many other cryptocurrencies have seen over the past decade, investors are right to wonder, “Can I put crypto in my IRA?”

IRAs — especially Roth IRAs — offer not just major tax advantages over buying crypto in a brokerage account, but also enable investors to roll over funds sitting in other retirement accounts, like an old 401(k) or 403(b).

Not to mention that the long-term nature of retirement accounts makes them the perfect pair for HODLers.

How to Invest in Crypto with an IRA

When most people think of IRAs, they think of public market offerings like stocks, bonds, mutual funds, and so on. But as many savvy investors are discovering, there’s a lot more you can invest your retirement dollars in using a self-directed IRA — including alternative assets like art, crypto, farmland, and private equity.

Self-directed IRAs provide all the same tax advantages of any IRA custodian, only you get to decide how you invest your money. So a crypto IRA is just a self-directed individual retirement account that lets you invest in cryptocurrencies. And while these IRAs used to involve mountains of paperwork and high fees, that’s no longer the case.

Today, you can open an Alto CryptoIRA® in minutes and begin trading crypto with the tax advantages of an IRA in a matter of days. And with $10 investment minimums, you don’t have to commit the large sums required by many other crypto IRAs. So you can start small if you’re unsure how much of your portfolio to allocate to crypto.

Why Can’t I Hold the Keys to My Crypto IRA?

While all the types of investments you can make with a self-directed IRA might be surprising, there are restrictions. This is where keys come into play.

Custody and Self-Directed IRA Prohibited Transactions

All individual retirement accounts, including self-directed crypto IRAs, are subject to U.S. tax codes. Section 408 of the Internal Revenue Code defines an IRA as “a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries.” As a result, IRAs must be held in the custody and control of a bank, trust company, or other qualified custodian.

These trustees or custodians, in turn, are responsible for ensuring that money held in retirement accounts is not used improperly. After all, the government wants to make sure bad actors don’t misuse retirement vehicles to illegally dodge taxes.

For example, you can’t invest IRA funds in a second home or a personal business. Because you could, in theory, use that second residence as a vacation home — and you would certainly benefit if your personal business enjoys an injection of capital courtesy of your tax-advantaged retirement funds — you’re considered a disqualified person. So too is anyone who controls the “assets, receipts, disbursements, and investments” or who may exert influence over decisions regarding the investment.

This is at the heart of what makes holding your own keys within an IRA legally problematic.

Not only does holding the keys to your crypto appear to be direct possession of the investment instead of the trustee. When a custodian has no way of verifying transfers of cash or crypto in and out of wallets held by you, there’s no way to protect you from potentially severe tax consequences.

Nor is this a theoretical issue.

Checkbook LLCs, Crypto Keys, and the IRS

In the November 2021 court case, McNulty v. Commissioner, the IRS charged that a self-directed IRA had been improperly used to purchase gold coins to be held as an investment. What’s more, the defendant later sold the coins, failing to report her profits.

Investing in gold within an IRA is not illegal, but taking physical possession of coins by the taxpayer is.

While crypto wasn’t the focus of the case, it put a spotlight on the challenges self-directed IRA custodians face in keeping a watchful eye over (and preventing abuse of) accounts. Challenges made especially difficult by the inherent anonymity of crypto. (Remember, you send to public keys, NOT names of account holders.)

The court ultimately sided with the IRS, saying that Section 408 of the Internal Revenue Code is clear: All assets in an IRA must be in the custody and control of a bank, trust company or other qualified custodian. Under these rules, holding the keys to crypto in your IRA is prohibited and could disqualify your entire IRA.

For these reasons, while the Alto CryptoIRA offers secure custody and all the tax benefits of an IRA, we don’t allow investors to hold the keys to their crypto, whether in a so-called checkbook IRA or otherwise.

Diversify Your Retirement Portfolio with a Crypto IRA

For some, not being able to hold their keys could be a non-starter. But for those savvy investors who recognize the tax advantages, especially in conjunction with compounding returns over years or even decades, an IRA could be a smart way to allocate a portion of your portfolio to crypto.

Learn more about Alto CryptoIRA to find out how you can buy and sell crypto tax-free or tax-deferred — depending on whether you choose a traditional, SEP, or Roth IRA — while taking comfort knowing your crypto is held 1:1 in institutional-grade hot and cold storage.

Originally published at https://www.altoira.com on October 27, 2022.