This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult a tax, legal, and/or CPA before engaging in any transaction.
Importantly, this article covers methods that you can use to completely avoid the capital gain tax on cryptocurrencies – with the blessing of the IRS. It’s not so much about how to report cryptocurrency on your taxes after you have a gain, as it is about how you make your investment before you have a capital gain. Being able to open this type of account without an employer fits the needs of independent-minded people like a glove.
Do I Pay Taxes on Cryptocurrency Gains?
The answer is a conditional “yes” that some people will have to pay taxes on gains from cryptocurrencies. The Internal Revenue Service is not going to pass up a chance to collect taxes on a capital gain, even one that comes in the form of a currency with no government backing.
However, and very importantly, you can avoid paying all capital gain taxes on crypto by making your original investment with a Roth Solo 401k.
On the other hand, Bitcoin, Ethereum, and other cryptocurrencies are taxable if bought and sold through almost every broker account. The IRS classifies crypto as “property” for tax purposes. This means your virtual currency is taxed in the same way as any other assets you own. A common way of thinking of crypto is the same as you may think of gold. For IRS purposes, gold, stocks, and crypto all fall into the same category as an investment property that owes taxes when sold or traded for a capital gain.
This year’s 2021 tax returns (filed in 2022) will be a big year for the IRS to set standards for how to report cryptocurrency on your taxes. This is the year that cryptocurrencies took off big time. Investment studies show that more than half of current Bitcoin investors made their first investment over the last 12 months. During the same time, the crypto market hit multiple all-time highs and lows, leading to large gains and losses for many investors.
The IRS has not hesitated to define how to report cryptocurrency on your taxes. The basics of cryptocurrency taxation were outlined back in 2014 with IRS Notice 2014-21.1. Nabers Group was ready. Nabers Group is by far the most experienced IRS-approved document provider in the industry helping you to compliantly structure your retirement account so you can not only purchase crypto but hold your own keys.
How to Avoid Capital Gains Tax on Crypto
The best news is that with a Roth Solo 401k, not only are crypto (and other) 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 great news, but not the full story.
For some people, the Roth Solo 401k is not always the right answer for this time in their life. With a Roth, you do have to pay the taxes on your original investment funds (but not the gains). For many exceptionally good reasons, some people want to defer paying taxes on their retirement investment funds. This is where the traditional Solo 401k helps with crypto investments to avoid capital gains taxes until you are in a lower tax bracket after retirement. With a Solo 401k, you reduce this year’s income so that you pay less income tax today, invest that money in crypto, but do not owe the capital gains tax for many years to come – only when you withdraw the money gradually while in a lower tax bracket during retirement.
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. How to report cryptocurrency on your taxes will not be a concern until many years in the future when the IRS no longer has a spotlight on the subject. But that is only the beginning of the benefits that come with a Solo 401k…
Both the Solo 401k and the Roth Solo 401k provide you with the highest contribution limits allowed. Retirement contributions that you fully control and can invest in crypto or other nontraditional assets. The IRS approved contribution limit for a Solo 401k increases based on inflation (typically annually). In 2021, the total Solo 401k contribution limit was $58,000. In 2022, it increased to $61,000 with a catch-up contribution allowance of an extra $6,500 for those 50 or older. That brings the possible 2022 contribution total to $67,500. If a spouse is also making maximum contributions, the joint annual contribution can be as high as $135,000.
If you’re looking to save on taxes and invest with freedom – then you need to know about the Solo 401k.
How to Report Cryptocurrency Transactions on Your Taxes
Astute investors understand that the IRS will be looking closely at how to report cryptocurrency on your taxes for the next couple of years. Here is where we are at today. For the first time ever, the IRS placed a question at the top of Form 1040 that asks, “[a]t any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” For tax purposes, that means you can no longer claim you didn’t know you were supposed to report it.
If you check the box indicating that you had a financial interest in crypto, the IRS will be looking to see that form 8949 is attached to your return (Sales and Other Dispositions of Capital Assets). The two basic sections of that form are for short-term and long-term capital gains. But you don’t owe taxes until the cryptocurrency is sold. Simply buying virtual currency with U.S. dollars and keeping it within the exchange where you made the purchase or transferring it to your personal wallet does not mean you’ll owe taxes on it at the end of the year. If you do owe taxes on it, the short-term capital gains tax for 2021 ranges from 10% to 22% depending on your income level for the year. The long-term capital gains tax for 2021 ranges from 0% to 20% depending on your income level.
Keep in mind that a Solo 401k or a Roth Solo 401k does not file a tax return. You will not have to check the box on your personal 1040 saying you have a financial interest in cryptocurrency as long as the crypto is held in one of these accounts. Unless you have sales of capital assets outside of these accounts, you will not have to file form 8949. Your Roth Solo 401k earnings will remain tax-free forever, even when you withdraw them after retirement. Your Solo 401k taxes are deferred until you withdraw them after retirement and are likely to be in a lower income bracket.
Without a Solo 401k, these are the most common crypto activities that you do need to report on your personal tax return:
- Selling your crypto for cash.
- Trading one cryptocurrency for another digital currency.
- Using cryptocurrency to make purchases, pay bills, or other financial transactions (every day more crypto debit cards are being accepted by vendors).
Those are the most common but not the only times you have to report crypto earnings. The IRS also requires you to report transactions involving:
- Mining crypto yourself or owning a stake in crypto mining.
- Being paid in crypto by others.
- An airdrop of tokens resulting from a hard fork in the crypto computer code.
If your only crypto-related activity this year was purchasing crypto with U.S. dollars, you don’t have to report that to the IRS. That means you can personally buy and hold crypto without informing the IRS as long as you don’t sell it for a capital gain. On the other hand, you can buy, sell, and trade crypto all day long inside your Solo 401k without reporting it to the IRS.
The Tax Implications of Trading, Holding, and Using Cryptocurrencies
When you sell or exchange crypto for anything, including another investment, is when a taxable event happens if it is outside of your Solo 401k or Roth Solo 401k. If you are doing a lot of trading or even making purchases with crypto, every one of them is a taxable event. You may have avoided crypto taxes in the past, but this is the year that you can expect the IRS to crack down hard.
Regardless of how it’s acquired, you’ll need to record the value of the crypto in U.S. dollars when it’s received and report that income on your tax return. The IRS puts it this way: “A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.”
If you originally acquired Ethereum with a value of $2000, and it’s worth $4000 at the time when you have a future transaction, the future transaction generates a $2000 capital gain for you. Depending on how far in the future that transaction occurs will determine if it is a short or long-term capital gain. The difference between the amount you spent to buy/acquire the crypto (its cost basis) and the amount you earn from its sale/disposition is the capital gain or capital loss — the amount you’ll report on your tax return if it is outside of a Solo 401k.
There are a few methods outside of a Solo 401k that you can use to minimize the taxes owed. Holding onto your crypto for the long-term reduces the higher short-term tax. You can also offset capital gains with capital losses or use Highest In – First Out (HIFO) Accounting.
Better yet, you have a right and a need to take full control of your taxes if you are a freelancer, independent contractor, are otherwise independently employed, or even if you have a side business and are still employed by someone else. The ultimate way to eliminate or minimize taxes on crypto is with a Solo 401k.
What To Do If You Made a Mistake On Your Cryptocurrency Tax Return
If you were not aware that their crypto transactions had a tax reporting requirement, you can submit a tax amendment to reduce your risk of an IRS audit. We don’t yet know what the possibility of an audit is. Some people believe crypto transactions are untraceable because of the anonymous, decentralized nature of blockchain. However, crypto transactions are distributed public ledgers, which means anyone can view the ledger at any time. The anonymity goes away whenever someone associates a crypto wallet address with a name.
If you want to correct passed transactions not reported to the IRS, you can amend your tax return for whichever year(s) you didn’t include your crypto activities. You have three years from the date that you filed your return to amend it. It’s a basic three-step process:
- Determine the fair market value of your cryptocurrency at the time you acquired it.
- Determine the fair market value of your cryptocurrency at the time you traded, sold, or spent it.
- Add the new or updated information to IRS form 1040X to submit it.
Of course, you’ll also need to send a check for any taxes that you owe or possibly receive a refund if you had losses.
If you are new to crypto, still aren’t holding it in a Solo 401k, and trying to figure out how much tax you owe for 2021, you can get a reasonable estimate using this crypto tax calculator.
Invest in Bitcoin — Pay Less in Taxes
If you didn’t know you can open a 401k without an employer you’re not alone! If you’re looking to save on taxes and invest in crypto with freedom – then you need to know about a Solo 401k.
Because 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.
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.
Stay ahead of the learning curve with this series of articles.
- Bitcoin Basics – Part One Crypto Education Series
- Bitcoin In Your Solo 401k – Part Two Crypto Education Series
- Grow Your Gains Tax-Free with Roth Solo 401k – Part Three Crypto Education Series
- Bitcoin FAQ – Bonus Crypto Education Series
Nabers Group will continue sharing information as the technology and investment opportunities evolve.
IRS Notice 2014-21.1
how to report cryptocurrency on your taxes
IRS form 1040X
crypto tax calculator