If you purchase Bitcoin and later sell it to earn a profit, you will be liable to pay capital gains taxes on it. It doesn’t matter if you trade Bitcoin for dollars or trade it for other cryptocurrencies and earn profit. Similarly, exchanging Bitcoin for merchandise or services post its value appreciation would also attract capital gains taxes.
The IRS has issued guidance on cryptocurrency tax matters twice through IRS Revenue Ruling 2014-21 and 2019-24. The crucial determination made by the IRS in 2014 was that digital currency is considered property, not currency, for the purpose of federal taxes. As a result, profits from cryptocurrency trading are subjected to similar treatment as profits from stock trading, since both are categorized as property for tax purposes. However, handling cryptocurrency profits like stock profits is a straightforward process, but the rules pertaining to tax liabilities for Bitcoin and other digital currencies are unclear and complex due to the fact that cryptocurrency can be bought with dollars, fluctuate in value, and exchanged for various goods or cash. These exchanges are not typical in stock trading, and therefore, taxes for digital currency trading can be puzzling.
Trading of crypto and short-term vs. long-term gains
Similar to owning a personal stock portfolio, it is essential to monitor the value of the cryptocurrency you purchase and its value when exchanged or sold. For instance, if you gain $20,000 by purchasing Bitcoin for $30,000 and later selling it for $50,000, the gain is liable to tax at either short- or long-term capital-gains rates, depending on the duration you owned the Bitcoin. If you held Bitcoin for more than a year, you acquire the favored long-term capital-gains rate ranging from 0-20%. Mainly, the rate is 0% for low- to mid-income earners (typically less than $40,000 for singles and $81,000 for couples), 15% for mid- to high-income earners (generally up to $445,000 for singles and $510,000 for couples), and 20% for those with high income ($445,000 for singles and $510,000 for couples).
In case you kept the Bitcoin or any other cryptocurrency for less than a year, you will be subjected to short-term capital gains rates that range from 0-37%, depending on your modified adjusted gross income.
Exchanging one crypto for another
When you swap one cryptocurrency for another, it results in a taxable gain. For instance, you would be liable for a gain of $20,000 if you invested $50,000 in Bitcoin one month and later exchanged it for Ethereum worth $70,000. The taxable gain applies whether you held the Bitcoin for a brief period and exchanged it for a different cryptocurrency or held it for many years.
Using crypto for goods or services
Tax is applied to the increase in value of cryptocurrency between the time it was bought and when it is used to purchase goods or services. An example of this could be if an individual bought a Tesla using $100,000 worth of Bitcoin, they would need to trace the purchase date of the Bitcoin and pay tax on the increase in value. If the Bitcoin was purchased for $40,000, then there would be a $60,000 gain when it is applied towards the Tesla purchase. If held for a year or more, the gain is considered long-term and is taxed at a preferred rate. If held for less than a year, the $60,000 gain is taxed at the short-term capital gains rate.
Crypto losses
If you incur a loss from buying and then selling Bitcoin or any other cryptocurrency, you are eligible for a tax loss. Losses can arise from selling or exchanging crypto for other goods or services at a loss. These losses can be used to offset other crypto gains. Short-term losses can offset short-term gains, and long-term losses can offset long-term gains. Crypto losses can also potentially be used to offset gains from stocks or mutual funds. If the crypto losses exceed gains from stocks, ETFs, and mutual funds, you can use up to $3,000 of the loss to offset other sources of income such as wages or self-employment income. Unutilized losses can be carried forward to future years and netted against any crypto or stock-trading gains.
Crypto forks and airdrops
In 2019, the IRS provided guidance on two distinct occurrences that can happen on a cryptocurrency blockchain. The first is a fork, where there are various types that may take place. For taxation purposes, crypto owners should be aware that any new coins resulting from a hard fork will be considered taxable as ordinary income to the recipient. Additionally, the IRS also clarified in 2019 that existing cryptocurrency holders receiving an airdrop of new coins will be taxed as ordinary income at regular income-tax rates. Airdrops usually involve the distribution of free coins or tokens to promote the currency.
Crypto mining is ordinary income taxed at regular rates
When individuals engage in cryptocurrency mining, the income they receive is considered ordinary income for tax purposes. This is because cryptocurrency mining involves providing a service to a blockchain network using hardware devices. In return for this service, individuals receive cryptocurrency from the network, which is subject to taxation by the IRS. The taxable income received in cryptocurrency is equivalent to being paid in dollars, and therefore, individuals are required to pay regular ordinary income tax rates and self-employment tax on this income. To minimize self-employment tax liability, many crypto miners opt for an s-corporation structure.
The value of the cryptocurrency upon receipt is the basis for tax-reporting purposes. If the value of the cryptocurrency goes up after receipt, you will owe capital-gains tax on the increase in value when the cryptocurrency is sold or exchanged later on. For example, if you received $1,000 worth of Bitcoin for providing crypto-mining services and the value of this cryptocurrency went up, resulting in it being sold or exchanged for $1,500 three months later, the initial $1,000 would be considered taxable income. This type of income is subject to standard income-tax rates, which can range from 0-37%. The $500 increase in the value of the Bitcoin after it was received will be treated as capital-gains income.
Can You Hold Cryptocurrency in a Roth IRA?
To have cryptocurrency as an asset in your Roth IRA, you’ll have to create an account with a specialized platform that provides this service.
Opting to invest in a Roth IRA rather than a standard brokerage comes with the benefit of tax savings as you won’t be subjected to capital gains taxes for selling investments that appreciate in value. While high-risk investments offer enticing potential returns, the tax savings can accumulate greatly, but the chance of potential losses remains high as well.
Even though custodians of Roth IRA accounts usually do not provide direct access to investing in cryptocurrency, they frequently offer crypto-related investments such as coin trusts, futures, and stocks that have exposure to crypto.
Pros
There is a possibility of earning substantial profits without being liable for taxation on them.
One potential strategy to enhance the diversification of your portfolio.
Cons
It is likely that in order to have direct ownership, one would need to collaborate with a recently established and minor custodian.
Your holdings may be impacted by fees. Crypto IRAs typically charge between 1% to 2% for every purchase and sale, whereas major custodians usually don’t impose trading fees.
Your financial planner may not have the necessary knowledge to offer guidance on cryptocurrency.
Cryptocurrencies and Roth IRAs
Let’s start with some basic information on Roth IRAs and the regulations set forth by the IRS.
By contributing after-tax dollars, a Roth IRA allows for investment opportunities that are not taxed on any subsequent gains. However, early withdrawals prior to retirement age will result in penalties.
Regulations imposed by the Internal Revenue Service dictate the functioning of these accounts, such as the allowable investment categories. Holding artwork or a coin collection is not permitted, but virtual currencies are acceptable.
It is not possible to transfer your existing cryptocurrency into a Roth IRA; any additional deposits to the account must be made using cash.
Investments are not reviewed, approved or endorsed by the IRS. The Commodity Futures Trading Commission governs U.S. derivative markets and has cautioned investors to be wary of marketing claims that promote virtual currency retirement accounts as “IRS approved” or “IRA approved.”
Owning cryptocurrency directly: What you should know
Major platforms don’t offer this option
It is crucial to differentiate between the rules governing Roth IRAs and the offerings of different custodians.
Although cryptocurrency can be held in a Roth IRA according to IRS regulations, customers of certain custodians, such as Vanguard, Charles Schwab, and TD Ameritrade, are not necessarily offered this option.
Nonetheless, some custodians permit holding cryptocurrency in a Roth IRA, such as Bitcoin IRA, Bit IRA, and iTrustCapital. These companies primarily emphasize cryptocurrency investment and do not offer a range of investment types, such as stocks, mutual funds, and ETFs, like traditional financial firms.
Transaction fees apply
Compared to traditional investment firms, the fees for purchasing crypto can be steep and occasionally concealed. In contrast, you may encounter infrequent startup charges with traditional IRA custodians.
Crypto platforms typically levy a transaction fee of 1% to 2%. For instance, purchasing $1,000 worth of cryptocurrency and subsequently selling it for $2,000 would subject you to a fee of $30 to $60.
Generally, transaction fees are not imposed by the majority of large financial custodians. Though mutual funds or exchange-traded funds (ETFs) possess expense ratios, it is frequently possible to discover inexpensive alternatives. As an illustration, suppose you invested $1,000 in an index fund with an expense ratio of 0.02% and the value rose by $100 over 10 years. In that case, you would incur just $29 in fees throughout the whole decade.
You might need a separate IRA for traditional investments
Considering cryptocurrency as a constituent of a varied investment portfolio, along with conventional investments, is a possibility. However, most crypto IRAs do not enable possession of conventional investments. In this case, how can one possess both?
You could consider opening multiple Roth IRA accounts with different custodians. While the IRS restricts the amount of new funds that can be added annually to each Roth IRA account, there are no limits on the number of accounts you can possess. This means that you could establish a Roth IRA with a brokerage firm for conventional investments and contribute $1,000. Next, you could set up an additional Roth IRA with a different company that supports cryptocurrency and add $500.
An alternative choice for those who possess a Roth IRA account is to transfer a certain amount to a fresh account solely for cryptocurrency.
Alternatives to owning crypto directly
By being open to flexibility, it’s possible to obtain financial exposure to cryptocurrency without actually possessing cryptocurrency. A number of reputable custodians, such as Charles Schwab and Fidelity, provide investment options related to crypto.
Stocks
Many companies that are publicly traded provide the physical and digital infrastructure that is utilized in the world of cryptocurrency. A widely used cryptocurrency trading platform, Coinbase, is an example of such a company. Various payment companies, such as Block (which owns the Square brand) and PayPal, are in the process of developing lines of business related to cryptocurrency. Nvidia, a chip manufacturer, has close ties to crypto miners. Investors who do not wish to select individual stocks may consider investing in ETFs such as iShare’s Blockchain and Tech ETF, which package multiple crypto-related companies in a single investment product.
Trusts
To have cryptocurrency in a Roth IRA with a traditional custodian, the best option is to invest in a crypto trust. Crypto trusts are legal entities that hold cryptocurrency which you can invest in. They are similar to publicly traded securities and have ticker symbols and shares that can be bought.
Although trusts provide a simple way to access crypto via conventional methods, they may not accurately mirror the fluctuating prices as investors desire. Nonetheless, they still offer a convenient approach to monitor the performance of a particular cryptocurrency without having to purchase it directly.
Futures
Another type of financial instrument developed to replicate the value of certain digital currencies is known as crypto futures. In contrast to crypto trusts, these offerings do not possess any actual cryptocurrencies. Rather, managers utilize futures, which are contracts for a specific time period that grant the option to buy or sell a product at a predetermined price, in order to try to attain the value of a particular cryptocurrency or a collection of them.
Due to the costs involved in futures trading and the inherent uncertainty, the price of the underlying coin may be lagging. One can opt for trading futures directly, however it involves complexity. Alternatively, an ETF utilizing this strategy may be purchased.
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