The rise of cryptocurrencies is getting a lot of press lately, with Bitcoin – the largest of them by market cap – getting the lion’s share of the coverage. Do they belong – Bitcoin in a Self-Directed IRA?

Is there a place for a Bitcoin in a Self-Directed IRA? Or a Litecoin or Ethereum IRA? Or a Ripple IRA? Sure. But be very careful before you commit funds and try to actually add cryptocurrencies like Bitcoin to your IRA or other self-directed retirement account.

Let us consider Bitcoin and crypto in general from some different perspectives. Do cryptocurrencies such as Bitcoin warrant a place among other alternative asset classes as a way to help diversify a portfolio? A few months ago, people like Citigroup Chairman Jamie Dimon were dismissing Bitcoin as a fraud on the market. A Dutch tulip bubble waiting to happen.

On the other hand, a recent paper from a Johns Hopkins University professor and a Maryland pension fund officer is suggesting that it is time for pension funds and other institutions to consider cryptocurrencies like Bitcoin for their own portfolios.

Why? The answer lies in the volatility of the asset class: Cryptocurrencies like Bitcoin are subject to big price swings in short periods of time. Changes of up to 25 percent and more in a single day are not uncommon. In some currencies, they are routine.

They are also not yet closely correlated with any other asset class. A small event like Bloomberg adding a new cryptocurrency asset to its trading terminal can cause a massive price swing that has no effect on the rest of the market. A single big holder dumping shares can send prices plummeting – and again would have no effect on stocks, bonds, real estate, or anything else besides maybe other cryptocurrencies.

So someone with a Self-Directed IRA who is a big fan of Harry Markowitz and Modern Portfolio Theory might be very attracted to the idea: Adding a very small exposure of Bitcoin to your IRA – the paper’s authors recommend less than 2 percent – can potentially add a lot of alpha to a Self-Directed IRA portfolio without increasing the portfolio’s overall risk by much. Indeed, because the correlation between Bitcoin and other asset classes is so low, it may even reduce your Self-Directed IRA portfolio’s overall volatility.

Are Bitcoin in a Self-Directed IRA legal? 

If you do it right, holding Bitcoin in an IRA is legal. The IRS only prohibits a few types of assets from being included  Bitcoin in a Self-Directed IRA are not on the prohibited list.

But doing it right gets tricky very fast. Why? Because the law prevents individuals from taking direct possession of assets within their IRA. For example, you can own certain kinds of gold coins in your Self-Directed IRA. But you cannot keep them in a safe in your living room. If you do, and the IRS finds out, you could wind up losing not only the gold investment but also having the entire prohibited account distributed.

The same applies to cryptocurrencies. It is common, for example, for people to hold Bitcoin on a hard drive or digital “wallet” in their possession. But this would probably violate the law.

Chances are very good that a lot of people searching for “Bitcoin IRAs” now do not grasp this – and run the risk of making an illegal transaction.

Is Bitcoin or any other cryptocurrency a sound investment? Who knows? No one has a crystal ball, but its volatility and lack of any kind of ‘anchor point’ for its value suggests caution. But if you decide the risk is for you, and you want to hold it in an IRA, keep this in mind:

• Cryptocurrencies are very young, and the rules and legal precedents for how they will be handled in an IRA have not yet been established.
• You cannot hold the cryptocurrency directly. In practice, this probably means you can not hold the discs your cryptocurrency is stored on, directly, either.
• Consider holding Bitcoin indirectly, through BIT (Bitcoin Investment Trust) or other intermediaries. You may need to be an accredited investor to invest. But it will eliminate the complication of holding it yourself. You can have American IRA, LLC handle the transaction, which will keep the cryptocurrency safely out of your personal possession.
• Do not make any moves without a thorough understanding of prohibited transactions.
• Be prepared to get a third-party valuation. This is especially important if you are subject to RMDs, or soon will be subject to RMDs.