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.
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.
There has been a significant increase in the amount of marketing directed towards IRA owners for non-publicly traded investments. Many of these investment sponsors and promoters are using marketing slogans like “IRS Approved” or “IRA Approved”. Don’t be fooled though, as the IRS does not review or approve investments, nor do they comment or issue statements on investments in an IRA. In fact, the IRS recently revised and updated IRS Publication 3125 titled, “The IRS Does Not Approve IRA Investments,” in an effort to inform IRA investors.
IRAs Can Invest into Non-Publicly Traded Investments (Real Estate, LLCs and Precious Metals)
Yes, it’s true that a self-directed IRA can invest into real estate, LLCs, LPs, private stock, venture or hedge funds, start-ups and qualifying precious metals, among other things. However, just because you can invest in all of these assets doesn’t mean that you should. Make sure you’re investing your IRA into assets you are familiar with, and with persons and companies with whom you have thoroughly vetted. Non-publicly traded investments can be easier to understand and vet than a mutual fund prospectus, but you need to be careful when investing your funds with another person or when buying investments from third-parties who regularly sell to IRA owners using comforting, yet totally false, representations like “IRA Approved” or “IRS Approved.”
“IRA Approved” or “IRS Approved” Representations are False
In Publication 3125, “The IRS Does Not Approve IRA Investments,” the IRS provided some guidelines for IRA owners to evaluate and protect their account from “IRA Approved Schemes.”
- Avoid any investment touted as “IRA Approved” or otherwise endorsed by the IRS.
- Don’t buy an investment on the basis of a television “infomercial” or radio advertisement.
- Beware of promises or no-risk, sky-high returns on exotic investments from your retirement account.
- Never transfer or rollover your IRA or other retirement funds directly to an investment promoter.
- Proceed with caution when you are encouraged to invest in a “general partnership” or “limited liability company”.
- Don’t be swayed by the fact that a bank or trust department is serving as an IRA custodian.
- Always check out an investment and promoter before you turn over your money.
- Educate yourself about IRAs and retirement planning.
- Exercise extra caution during tax season when it comes to making IRA investments.
As a self-directed IRA investor, you are solely responsible for investment decisions, and as a result you must make certain that you understand the investments you are selecting and the associated risks. Beware of slogans and terms like “IRA Approved” or “IRS Approved,” as such slogans are just false. In addition to the consideration from the IRS above, I’ve previously written my own “Self Directed IRA Investment Due Diligence Top Ten List” which includes additional tips and questions to ask when investing your hard-earned retirement plan dollars with others.
Take the IRS guidelines and my Top Ten List into consideration when investing your IRA, but in the end, don’t be scared about investing into non-publicly traded investments. Rather, keep the risk and opportunities in perspective, and realize that you may need to get out of your comfort zone by asking pointed questions, demanding additional documentation, or simply saying “no.” Remember: You are the best person to protect your retirement.