Grow your cryptocurrency gains tax-free with a Roth Solo 401k. Not only are gains tax-free, but you can avoid complicated IRS tracking and annual reporting requirements. Roth gains are not subject to tax. Roth Solo 401k accounts do not report on your 1040 personal tax return. That’s the good news, but not the full story.
Whether you purchase or mine Bitcoin and other cryptocurrencies, there are generally three things you can do with it after you own it:
- Keep it stored (saved) while anticipating future value growth.
- Exchange it for fiat money like USD.
- Buy goods and services directly.
The biggest takeaway is the ability to open a cryptocurrency exchange account in the name of your Solo 401k trust or Special Purpose LLC.
Crypto exchanges Gemini, Kraken, and Bittrex allow you to open a crypto exchange account using your trust, or SP LLC. This should be a brand new business exchange account – not a personal account. You cannot use a pre-existing crypto exchange account. No personal funds are allowed in this new crypto exchange account – retirement assets only. As long as the cryptocurrency remains in your Solo 401k, it can grow tax-free until withdrawn. In the case of a Roth Solo 401k, the gains that you withdraw are tax-free. With a traditional Solo 401k, you may owe taxes as it is withdrawn as retirement income.
The IRS tax treatment of cryptocurrency has created a favorable tax environment for Solo 401k and Roth Solo 401k accounts.
How the IRS Taxes Cryptocurrencies
In years gone by, taxpayers with cryptocurrencies might have claimed ignorance on crypto gains that happened outside of a retirement account. Thankfully, that changed drastically with the 2020 tax forms. The cryptocurrency question is now the first item on the 1040 form, just below the individual’s contact information.
Under U.S. tax law, the IRS classifies cryptocurrencies as property and subject to capital gains taxes. On the other hand, you only owe taxes when those gains are realized. The IRS has released two notices describing how existing general tax principles apply to cryptocurrencies. These are IRS Revenue Ruling 2014-21 and 2019-24. (You may also want to see FIN-2019-G001 for more detailed information about Certain Business Models Involving Convertible Virtual Currencies.)
For federal tax purposes, the important determination by the IRS in 2014 was that cryptocurrency is property, not currency.
Important: no new cryptocurrency tax laws to note. The IRS Rulings determine how the IRS deals with crypto within existing tax law.
Cryptocurrencies not in retirement accounts are treated much the same as Wall Street stocks. Just because it went up in value last year or over the past few years doesn’t mean that you owe taxes this year. You only report gains to the IRS in years when making a sale in exchange for fiat money. Or in the case of crypto that you spend, you report to the IRS in years that you spend it.
“The Internal Revenue Service (IRS) is aware that “virtual currency” may be used to pay for goods or services, or held for investment.”
~ IRS Revenue Ruling 2014-21
The IRS refers to spending crypto on general consumer products like fast foods, vacations, or luxury products as “convertible” virtual currency. These common transactions are very different from stock exchange transactions. While you cannot purchase consumer products with a stock certificate, it is becoming more common to buy dinner or even a car with cryptocurrency. So, when the IRS treats crypto similar to stocks, being able to use crypto to directly make consumer purchases complicates the tax implications. The fact that crypto values are independent of fiat money values also complicates taxation. But the IRS has answers to these situations.
Paying for Goods and Services with a Crypto-Wallet
One pays taxes on increase in value when you pay for good and services with cryptocurrency using personal funds. For instance, you might not be able to currently buy a luxury car directly from a manufacturer’s dealer using Bitcoin. On the other hand, some second-tier dealers will gladly sell you a Lamborghini or Porsche using only Bitcoin.
In this case, a $100,000 Bitcoin purchase requires that you track the original value when the Bitcoin was acquired. You then pay tax on the increase when you spend it. If you originally acquired the Bitcoin for $50,000 and it increased to $100,000 before you bought the car, you would owe taxes on the $50,000 gain. Say you held it for more than a year, the tax rate is on a long-term gain. Otherwise if held for less than a year, it is taxed at a higher rate as a short-term gain.
If you are buying dinner with a Bitcoin Wallet twice a week, this is going to make recordkeeping intense and complicated in a hurry. A better option is growing it tax-deferred in a Solo 401k and paying taxes on it as income in the year you withdraw it. Or growing it tax-free in a Roth Solo 401k and never paying taxes on the gain.
By investing and trading crypto with a Solo 401k, you can bypass the tracking and annual tax reporting because these transactions are not subject to tax and do not show up on your 1040 personal tax return.
Another possibility is cryptocurrency mining and staking. If it is not in a tax-deferred or tax-free account, the crypto is first treated as ordinary income for tax purposes and reported on your personal 1040. If the value increases, you will owe capital gains tax on the increase in value when the crypto is later spent or sold. For example, $1,000 of mined crypto is taxed as ordinary income and if you sell it six months later for $1,750, capital gains are owed on the $750 increase.
Crypto Losses and Foreign Holdings
Of course, when capital gains apply, you can also have capital losses. Losses from one crypto trade can offset other crypto gains. Short-term crypto losses offset short-term crypto gains. Long-term crypto losses offset long-term crypto gains. Crypto losses can also offset stock market gains including gains on stock, ETF, and mutual funds. Additionally, losses can offset other income such as wages or self-employment income. You can also roll losses forward to future tax years to offset future gains.
Record keeping and IRS reporting are the responsibility of the crypto owner. IRS reporting of cryptocurrency gains and losses is on form 8949. You file both Form 8949 and personal 1040 tax return. The major providers of crypto in the U.S. do report crypto transactions and trading to the IRS.
Some people have held their crypto and traded it outside of the US. However, this has its own complications. The foreign bank account rules (FBAR) have a pending rule change. This includes crypto holdings falling under the definition of a bank account and would thus result in foreign bank account reporting of crypto assets. Anything over $50,000 in value may also require the filing of a Statement of Specified Foreign Financial Assets, or Form 8938. But investing in cryptocurrency with a Solo 401k or Roth Solo 401k is much less complicated.
Since a Solo 401k Plan is exempt from tax, under Internal Revenue Code Section 401, all income and gains from the cryptocurrency investment will flow back to the Solo 401k plan without tax.
Minimal Tax or Tax-Free with Traditional Solo 401k and Roth Solo 401k Accounts
Bitcoin has become the most well-known cryptocurrency since it emerged in 2009. Because crypto is not a traditional investment, acquiring it and managing it is still a bit of a mystery for some people. It is a good fit with a Solo 401k or Roth Solo 401k because the Internal Revenue Code does not describe what a retirement plan can invest in, only what it cannot invest in. The only thing that a 401k cannot invest in is collectibles (artwork, precious gemstones, stamps, antiques, etc.).
Also, cryptocurrency does not generally fall into any category of prohibited transactions. Therefore, it is an allowable investment for a Solo 401k or Roth Solo 401k. Additionally, the IRS tax treatment of crypto has created a favorable tax environment for these accounts. When a retirement account generates income or gains from the purchase/sale of a capital asset, the retirement account doesn’t pay tax on the transaction.
Distribution taxes defer for the future. Therefore, when you use retirement funds to invest in cryptocurrencies, such as Bitcoin, the investor can defer or eliminate (in the case of a Roth Solo 401k) any tax due from the investment.
Every investor should perform diligence before investing in virtual currency and the underlying blockchain technology.
Note: Retirement account investors who have an interest in mining Bitcoin versus trading may become subject to the Unrelated Business Taxable Income rules. This is if the “mining” constitutes a trade or business.
Few, if any traditional broker-dealers providing retirement accounts allow you to invest and trade cryptocurrency in their IRAs and Roth IRAs.
Stay ahead of the learning curve with this series of articles. Nabers Group will continue sharing information as the technology and investment opportunities evolve.
Thanks for helping me understand that cryptocurrencies are subject to capital gain taxes according to U.S. laws and as stated by the IRS. It seems that working with a crypto tax lawyer is the best way to understand these regulations and prevent violations as an investor. So those who are interested in these fields should definitely work with professionals because I think it will be for their own protection as well as their investments.