What you need to know about 401(k) accounts with bitcoin

What you need to know about 401(k) accounts with bitcoin

Soon, more Americans will have the opportunity to invest 401(k) funds in Bitcoin. It's important that you understand the risks if you're going to do this.

Fidelity Investments, the largest 401(k) wealth management company in the United States, recently made national headlines with the announcement that it will offer direct Bitcoin (BTC) allocations in its 401(k) accounts. Social media was abuzz following the announcement, as Fidelity manages over $2 trillion in 401(k) accounts. The company said it would allow bitcoin allocations of up to 20% in clients' 401(k) accounts. This represents a potential $400 billion in new capital that could be used to purchase Bitcoin.

Bitcoin has been held in retirement accounts for some time, either through self-directed individual retirement accounts (IRAs) or self-directed 401(k)s, through investment vehicles like the Grayscale Bitcoin Trust (GBTC), or even more recently through bitcoin futures ETFs. (Grayscale is a sister company to CoinDesk).

How are 401(k)s used?

A 401(k) account represents the largest way for most Americans to save for retirement. 401(k) accounts are intended as wealth-building tools that employers offer their employees to help participants save money and accumulate assets. Contributions are typically automatically deducted from paychecks and invested in a mix of stock and bond funds. In 2021, 401(k) balances reached their highest level in history. As the most important retirement planning tool, it is important to have a strategy and understand what assets you own and why you own them.

Traditionally, 401(k) participants use their accounts to purchase stocks and bonds in a cost-effective and tax-efficient manner. Participants often average costs over a long period of time for their 401(k) accounts with the goal of living off the income the portfolio generates through dividends and regular withdrawals.

Bitcoin is not a cash-flowing stock

It is important to understand that Bitcoin is not a stock. Bitcoin does not pay dividends or distribute capital gains to its holders. Other cryptocurrencies may distribute an "income" or return generated by stakes, but Bitcoin does not. Many stocks pay dividends to their shareholders and bonds pay a return to their holders. It is important to understand why an individual would invest funds in Bitcoin, especially in an account intended for retirement.

It is relatively easy to understand the concept of investing in cash-flowing stocks or high-yield bonds. The earnings from these traditional investments are typically reinvested along with new cash contributions each pay period until the 401(k) owner retires and begins living off the portfolio earnings. 401(k) participants typically use an aggressive asset allocation when they are young and change the asset allocation to become more conservative when they reach retirement age and begin withdrawing from the portfolio.

Bitcoin in a 401(k) portfolio as a hedge or new store of value

Bitcoin is viewed by many as a hedge investment. Many Bitcoin holders believe that, similar to investing in precious metals, it is wise to invest a percentage of one's wealth in an asset that is not controlled by a central authority. Bitcoin is an open, decentralized network, and many believe it is an emerging store of value. Many people view Bitcoin as an insurance-like instrument that will protect their assets in the event of a system failure. Allocating to an asset that is seen as a store of value and a hedge against government or central bank mistakes is a responsible and sensible approach.

Other investors believe that Bitcoin is an emerging technology that will shape the future of many industries. An allocation to Bitcoin from an emerging technology perspective would be similar to an allocation to a growth stock or a more specific equity strategy. Many 401(k) plans offer participants the option to invest in broad-based index funds or more specific, actively managed funds that may include stocks of large-cap or small-cap growth companies. Viewing Bitcoin as an investment in an emerging technology is a responsible way to view the asset.

It is important to note that an allocation to Bitcoin is an alternative allocation and should be taken with caution.

Develop an investment thesis and portfolio rules.

Before allocating funds to Bitcoin in a 401(k) or IRA, investors must determine why they want to make such a unique allocation. Allocating to Bitcoin simply because one believes the price may rise may not be the best decision. Investors must decide why Bitcoin should have a place in their portfolio - for example, as a market hedge or as an active allocation to an emerging technology - and then establish portfolio management rules.

401(k)s invested in Bitcoin and portfolio rebalancing.

As an investor approaches retirement, the portfolio's risk and volatility are typically reduced. This is usually done by reducing exposure to stocks and buying more bonds. This lower volatility protects the portfolio from excessive downside risk. When an alternative asset allocation, such as a position in Bitcoin, is added to a portfolio, new risk control rules must be considered. Bitcoin is an incredibly volatile asset and, if unmanaged, can grow into a very large position in a portfolio, increasing risk and volatility. In bear markets, a bitcoin position can deviate from the target allocation, which means investors need to have rules in place to bring the portfolio back to the target allocation. Using a rules-based approach to 401(k) management reduces the risk of emotions driving portfolio allocation - which in turn increases portfolio returns over time.

Just because Bitcoin is available doesn't mean you need it in your 401(k).

401(k)s and IRAs are very important accounts for almost all U.S. retirees. These accounts are the best tools we have for building retirement portfolios, so the money in these accounts is extremely important to the holder's future well-being. Investing in a speculative asset like Bitcoin just because it is suddenly available is not a wise decision. An investor must develop an investment thesis and establish portfolio management rules when investing in these alternative strategies.

The innovation and value capture opportunities available in the crypto asset class are unprecedented, but investors must be responsible in their allocation and portfolio management - especially when allocating to highly volatile assets like crypto. Investors should not treat their 401(k)s like a hedge fund or day trading account. These retirement accounts are best suited for long-term wealth accumulation and are valuable tools for preparing for future income needs. When used properly, Bitcoin can help investors achieve these goals. However, like any other alternative asset, if used incorrectly or irresponsibly, it can harm investments over the long term and make retirement much more difficult.