Bitcoin, Ethereum, Litecoin, and other cryptocurrencies have seen dramatic price increases this year. Have you thought about cashing in? Are you wondering how will you be taxed?
Cryptocurrency is a Capital Asset
The IRS has clearly stated that cryptocurrency (aka virtual currency) is a capital asset like property. And therefore, the buying and selling of it for profit results in short-term capital gain if held for under one year, and long-term capital gain if held for over a year. Short-term capital gain rates are based on your regular income tax bracket, while the long-term capital gains rate is 15-20%, depending on income level. IRS Notice 2014-21.
So, for example, let’s say I bought 10 Bitcoin in June 2017 for $25,000 US dollars when the price of Bitcoin was approximately $2,500. I decide that in December 2017 that I would like to sell my Bitcoin. The price is now approximately $16,500 per Bitcoin, so my holdings are now worth $165,000. As a result, my $25,000 investment has generated a taxable profit of $140,000. Since I owned the Bitcoin for less than one year, the income will be short-term capital gain income and I will pay at my regular federal rate.
If I instead held the cryptocurrency until July 2018, then I would have long-term capital gain and would be paying tax at a much lesser rate.
Any realized gain from the cryptocurrency profit is taxable. This is the case if you exchanged Bitcoin for other cryptocurrency, or for goods or services. In this instance, you take the value of the Bitcoin in US dollars at the time of the exchange for other property and treat whatever gain you have when that Bitcoin was exchanged (at the value of the other property) as your taxable gain. Let’s say you bought 10 Bitcoin in 2015 for $250 per Bitcoin for a total purchase price of $2,500. You decide to exchange one Bitcoin, valued at $16,500 in December 2017, for 17 Ethereum valued at approximately $500 per Ethereum. Your gain on the Bitcoin being exchanged is the value of the Ethereum, $16,500, minus the cost of the Bitcoin, $250, for a long-term capital gain of $16,250.
Cryptocurrency mining is the process of using servers and other computers to verify the blockchain and transactions that are the backbone of the cryptocurrency. This IRS has stated that income from cryptocurrency mining, whether received in dollars or cryptocurrency, is taxable as regular income. Consequently, if you have engaged in the cryptocurrency mining business or are otherwise self-employed doing cryptocurrency mining then the income you received is taxable at your ordinary income rates and it will also be subject to self-employment tax.
Retirement Accounts and Cryptocurrency
Retirement accounts such as IRAs and 401(k) can own Bitcoin and other cryptocurrency. This requires a self-directed IRA or 401(k) and some careful structuring. For a more detailed discussion on this topic, check out my prior article and video here. When gains are made from the sale of cryptocurrency, whether for US dollars or other cryptocurrency, there is no tax owed on the gain. And, if you use a Roth IRA or Roth 401(k), there will be zero tax owed when you pull the funds out at retirement. For traditional IRAs and 401(k)s you pay tax when you withdraw the funds at retirement and these distributions, as is the case for all traditional IRA or 401(k) distributions, are subject to tax at your ordinary income tax rate at the time of distribution.
If your self-directed IRA or 401(k) is invested into cryptocurrency mining, as opposed to holding cryptocurrency for investment, then the income from such mining activities will likely cause unrelated business income tax.
A recent article on Forbes by Bryan Ellis outlines the importance in making sure you understand self-directed IRA rules before you invest. Check out the excellent article and a quote from yours truly here. Also, Bryan has a significant amount of additional resources on his self-directed IRA website which you can access here.
How does the proposed Republican tax reform impact your retirement account? Well, if you save for education expenses for your kids or grand-kids using a Coverdell Education Savings Account, you’re not going to be happy as new contributions to Coverdell accounts are eliminated in the House Plan. Also, both House and Senate bills eliminate the ability to re-characterize Roth IRA conversions back to Traditional IRAs. This was a nice “do-over” the IRS allowed you to use if you regretted converting your Traditional IRA to a Roth IRA, and switched it back to a traditional IRA within certain time limitations. For my prior article on how a Roth IRA re-characterization works, at least for now, check it out here.
The only good news: It could’ve been worse. There was talk of drastic changes that would have essentially called an end to Traditional IRA and 401(k) contributions in favor of Roth-only contributions (or limiting Traditional dollars to $2,400 annually). Luckily, those ideas never made it into the legislation.
Here’s a brief summary of the two major changes effecting IRAs. In addition to the changes effecting IRAs, there are numerous proposals regarding employer retirement plans such as 401(k)s, but those changes only slightly alter the ways those plans function.
||Change to IRAs
||No More Coverdell Education Savings Accounts (ESAs) Contributions
||Coverdell accounts are used as a vehicle to contribute funds (up to $2k annually per beneficiary) for education expenses. It is usually used by parents or grandparents as an account to invest the money tax-free whereby the money in the account grows without being subject to tax and comes out tax-free for the beneficiary’s education expenses. There is no deduction for the contribution. The current proposal would eliminate the ability to make future Coverdell contributions. Existing accounts may still exist without new contributions or may be rolled to a 529.
|House Bill & Senate Amendment to Senate Bill
||End Roth IRA Re-characterizations
||Under current rules, you can convert your traditional IRA to a Roth IRA, and if you later decide that such conversions (and tax due) wasn’t a good idea, you are allowed to undo the conversion and go back to a Traditional IRA.
So what should you do now? If you’ve used Coverdell accounts or wanted to, make 2017 Coverdell contributions because they may be the last time you can do them. Also, if you’ve been thinking of converting a Traditional IRA to a Roth IRA, 2017 may be the last year you can do so, and still have the ability to re-characterize back to Traditional if you later decide against it.
If you are self-employed and use a SEP IRA to save for retirement, you should carefully consider moving those funds to a new Solo 401(k) (aka “Solo K”).
Both SEP IRAs and Solo Ks are retirement plans commonly used by self-employed persons with no employees, such as: Real estate professionals, investors, consultants, direct-marketing professionals, 1099 salespersons, and other small business owners. Here’s why: Both the SEP IRA and the Solo K offer big annual contribution amounts that far exceed the $5,500 ($6,500, if over 50) that you can put into a Roth or Traditional IRA. In fact, in both the SEP IRA and Solo K, you can contribute, depending on your income, up to $54,000 annually – $60,000, if over 50 in a Solo K. That’s almost ten times the contribution limit of an IRA. And, if you’re really trying to build up a retirement account you can retire on, you’re going to need to contribute more than $5,500 a year.
Now, if you have a SEP IRA, you should really look at changing that SEP IRA to a Solo K. Sure, SEP IRAs are good, but Solo Ks are great. Here are four major reasons why you should make the switch:
1. You Can Contribute More to a Solo K on Less Income
You can contribute more to a Solo K each year on less income. Let’s consider the following example: Sally is 41 and the 100% owner of Sally, Inc. She sells products online and Sally, Inc. is taxed as an S-Corp. The total cash flow income from her company is $8,000 and she ends up paying herself a W-2 of $40,000 for the year. Based on the $40,000 W-2, she could contribute the following amounts:
- SEP IRA – 25% of Wage Income: $10,000
- Solo 401(k) – $18K on the first $18K Wage Income, plus 25% of Wage Income: $28,000
That’s right: Sally can contribute $28K a year to her Solo K on a $40,000 W-2. If she was using a SEP, she’d only be able to contribute $10,000. The significant difference is that, under a Solo K, you get to contribute $18K on the first $18K ($24k, if 50 or over), plus you get to contribute 25% of the wage income.
Also, if you are looking to max out the Solo K contribution amount of $54,000, then you’d need to have a W-2 from the S-Corp of $144,000. However, if you were looking to max out contributions at $54,000 using a SEP IRA, then you would need to have a W-2 of $216,000. Bottom line: It’s easier to max out your retirement plan contributions with a Solo K. And, at lower W-2 levels, something S-Corp owners strive for, the contribution difference is significant. For more details on Solo K contributions, please refer to my prior blog article.
2. You Can Self-Trustee and Administer Your Solo K
All IRAs, including SEP IRAs, must have a third-party custodian – a bank, credit union or trust company – for the account. However, with a Solo K, you can self-trustee and can have control of the bank checking account and/or a brokerage account without having a third party as the trustee. This allows you to invest directly out of the Solo K and gives checkbook control. A valuable tool when investing a retirement account into alternative assets like real estate, notes, or private companies, as you can sign off on investments or process funds without waiting on a third party to process and approve your own funds.
3. You Can Loan Yourself Up to $50K from a Solo K
Under a Solo K, you can loan yourself half of the balance of the Solo K not to exceed $50,000. This is known as a “participant loan,” and is a great option to use when you need to access funds you’ve contributed and saved for retirement. Maybe you need funds to grow the business, pay for school expense, or take a trip to Vegas. Whatever the reason, good or bad, your hard-earned money can be accessed without penalty under a Solo K using the participant loan. Now, you will need to pay the funds back over five years with a set interest. But, this money goes back into the Solo K you’ve been building. For more details on the 401(k) loan, please refer to my prior blog article. Unfortunately, the participant loan cannot be done with a SEP IRA, and would actually result in a distribution, penalty and taxes.
4. No UDFI Tax on Leveraged Real Estate with a Solo K
If you self-direct your SEP IRA plan into real estate, you may have heard of a tax called “unrelated debt financed income” (or “UDFI”). This tax applies when you leverage your SEP IRA’s cash with debt. For example, you buy a rental property with your SEP IRA for $100,000. Of this $100,000, $40,000 comes from your SEP IRA’s cash and $60,000 is from the bank loaning your SEP money on the deal. By bringing in 60% debt to the investment, the IRS will require tax on 60% of the net income from the profits of the property. However, this tax on leveraged real estate does NOT apply to Solo Ks as Congress created an exemption for Solo Ks, but not SEP IRAs. So, if you self-direct and leverage real estate investments with debt, you’d be crazy to use a SEP IRA over a Solo K. The tax can be tricky to calculate for IRAs and requires a separate 990-T tax return. Check out my detailed webinar on the topic if you’d like to learn more.
There are a couple of downsides to the Solo K over a SEP IRA:
1. Solo Ks are more expensive to set up, as it requires an IRS-compliant plan document. Expect to pay around $1,000 – $2,000 for an IRS-compliant Solo K that you can self-direct and self-trustee. Under both a SEP IRA and a Solo K, you will have similar on-going annual fees to keep them compliant.
2. The other downside to a Solo K is that once you have $250,000 in assets or more in a Solo K, you must file a 5500-EZ tax return to the IRS each year. This return isn’t overly complex, but it is an annual filing requirement you’ll need to handle, or hire someone else to handle if you are self-administering your Solo K.
So, what if you have a SEP IRA and you want to move over to a Solo K? You’ll first need to establish a Solo K for your business by adopting an IRS-compliant Solo K plan. Once you do that, you can start making your new contributions into the Solo K and also roll over the existing funds from your SEP IRA (or other traditional IRAs).
The IRS announced new contribution amounts for retirement accounts in 2018, and there are some winners and losers in the bunch.
The biggest win goes to 401(k) owners, including Solo K owners, who saw employee contribution amounts go from $18,000 to $18,500. Health savings account (HSA) owners won a small victory with individual contribution maximums increasing $50 to $3,450 and family contribution amounts increasing by $150 to $6,900.
However, IRA owners lost with no increase in the maximum contribution amount for Traditional or Roth IRAs. The IRA maximum contribution amount remains at $5,500 and hasn’t increased since 2013.
Here’s a quick breakdown on the changes:
- 401(k) contributions also increased for employees and employers: Employee contribution limitations increased from $18,000 to $18,500 for 2018. The additional catch-up contribution for those 50 and older stays the same at $6,000. The annual maximum 401(k) (defined contribution) total contribution amount increased from $54,000 to $55,000 ($61,000 for those 50 and older).
- HSA contribution limits increased from $3,400 for individuals and $6,750 for families to $3,450 for individuals and $6,900 for families.
- IRA contribution limitations (Roth and Traditional) stayed at $5,500, as did the $1,000 catch-up amount for those 50 and older.
There were additional modest increases to defined benefit plans and to certain income phase-out rules. Please refer to the IRS announcement for more details here.
These accounts provide tax advantageous ways for an individual to either save for retirement or to pay for their medical expenses. If you’re looking for tax deductions, you should determine which of these accounts is best for you. Keep in mind there are qualifications and phase out rules that apply, so make sure you’re getting competent advice about which accounts should be set up in your specific situation.