You should be extremely careful if you consider holding non-fungible tokens, or NFTs, in an IRA.
In March, the IRS issued guidance (Notice 2023-27) regarding taxes and penalties related to NFTs in IRA accounts. Generally, collectibles are considered a “prohibited” investment and not allowed in IRAs. However, there are exceptions for coins under state law and certain gold, silver, platinum or palladium bullion.
These coins are not considered collectibles, so they are not a prohibited IRA investment. However, they must be held by an IRA custodian and cannot be held at home. The US Tax Court has ruled that people who kept gold coins at home were subject to taxes and penalties.
The following is a list of collectibles that are considered prohibited investments: any work of art; any rug or antique; any metal or gem; any stamp or coin; and any beverage, alcoholic or otherwise.
The IRS has indicated that certain NFTs may be considered collectibles “if the NFT’s associated right or property falls within the definition of collectible in the Internal Revenue Code.”
There are potential serious and expensive tax problems for individuals who hold these items in their IRAs. For example, if a collectible or other prohibited investment is held in an IRA, the original cost will be treated as a “taxable distribution” from the IRA. (This is known as a deemed distribution.) There will be a 10% early distribution penalty if the IRA owner is under 59 ½. The distribution amount is based on the original cost, even if the asset has decreased in value. (According to IRA expert Ed Slott, it is not clear how the IRS plans to apply this rule to an NFT in an IRA that is considered a collectible but was purchased before the March notice was issued.)
According to IRS Publication 590-A, a collectible does not need to be withdrawn from an IRA when a deemed distribution takes place. When the NFT is distributed from the IRA, amounts included in income as a result of the “deemed transaction” will not be included again in income. So the IRA owner will get credit for the basis to the extent that the original cost was treated as distributed.
Example: Joe, a 45-year-old man, invested $100,000 in an NFT linked to ownership rights to a collectible. NFT becomes worthless. The IRS will determine that Joe owes taxes on the $100,000 investment and a 10% penalty on the $10,000 even though the investment has no value.
Roth Exception: Investors who expect an NFT to appreciate in value may consider adding an NFT to their Roth account. If the Roth IRA NFT is considered a collectible, the investment will not be taxable if the distribution is considered “qualified.” To be eligible, the Roth IRA account must already have been open for five years and the owner must have already reached at least 59 ½. Because the distribution is qualified, no tax is payable even if the transaction is considered a deemed distribution.
Example: Edward is 60, and his Roth account was created three years ago. He invests $100,000 in an NFT, which is considered a collector’s item. Because the distribution is not yet qualified, the $100,000 is considered a deemed transaction, with a taxable distribution. If Edward waits until the Roth account has been opened for five years, no income tax will be due even though the transaction is considered a deemed transaction.
Prohibited Transaction Risk
The IRS indicates that if an NFT in an IRA is considered a collectible, the IRA NFT may result in a “prohibited transaction” as well as a deemed distribution. This situation would arise if the IRA owner uses the property for his own interest. In this situation, the tax consequences are catastrophic. The “entire” IRA will be disqualified and considered distributed as of the first day of the year in which the prohibited transaction occurred. Additionally, if the owner was under 59 ½, there would be a 10% early distribution penalty.
Bottom line: Holding an NFT in your IRA is a complex and risky business, and it can be expensive. Make sure you or your advisor understand IRS Notice 2023-27 before holding an NFT in your IRA.
Elliot Raphaelson welcomes questions and comments at [email protected].