Cryptocurrency Taxes: Know What You Don’t Know – 3 Rules of Three
Part 2: Three Types of Crypto Accounts
Hopefully, if you have decided to get into the cryptocurrency business, you have done so for the purpose of making a lot of money…and by that, I mean a lot of PROFITS. Of course, anytime you have a lot of profits, you will have the IRS and other tax agencies circling like sharks, looking to claim their share of those profits. Knowing the 3 types of crypto accounts, and when to utilize each, will help you minimize the damage at tax time!
This is Kelly Coughlin, CPA and CEO of EverydayCPA. This is Part 2 of the five-part series CRYPTOCURRENCY TAXES: Know What You Don’t Know – 3 Rules of Three. In this episode, we are going to help you understand the three types of accounts that can be used in your cryptocurrency business. This will help you better understand how to keep the tax sharks from a feeding frenzy on your crypto profits.
Taxman Targets Crypto Traders
Tax agencies hear and see and smell current cryptocurrency business practices, and are targeting the easy prey: crypto traders who don’t care about the rules; crypto traders who don’t understand the rules; and crypto traders who think they know the rules but actually don’t know the rules…in other words, they don’t know what they don’t know.
In a previous episode, we talked about the three sources of crypto revenues and profits. Today we are going to talk about the three types of crypto accounts. These are critical in establishing the foundation for how the profits are treated in your virtual currency business practices.
Minimizing or eliminating one of your biggest expenses, TAXES, is important in determining your overall all-in profitability. Taxes can consume about 50% of your gains. So we are not talking about chump change here. Other than the cost to acquire the currency, which is your biggest cost including electricity; by far your highest expense will be taxes…and this is true even with currency mining, if not structured correctly.
Three Types of Crypto Accounts
There are three types of crypto accounts in which you can conduct your virtual currency business:
1) A taxable account. This is an account that has already been taxed, like the account where your paycheck gets deposited. Perhaps you sent some of your savings to a cryptocurrency platform like Gemini or Kraken, etc., to buy and sell cryptocurrency. In this account, the earned income that produced it was subject to both payroll taxes like Social Security and FICA, PLUS income taxes. These funds have already been taxed. All FUTURE profits will also be taxed at either long-term or short-term rates depending on if you held the position for more than one year.
2) A non-taxable pre-tax account. The funds in these types of accounts have NOT been subject to INCOME tax but they have been subject to PAYROLL tax like SS and FICA. These are commonly known as IRAs and 401ks. (Note: Roth IRAs are NOT in this category). These accounts are temporarily exempt from income tax for certain types of income; only when you pull the funds out, will you then have to pay income tax on them. Since the income from these funds are specifically NOT earned income, which would be subject to payroll taxes. The distributions are NOT subject to payroll taxes, but they are subject to income tax. Recall you did not pay income tax on them when the funds first went into the tax-exempt account. In these accounts, you might have put new money into it from your EARNED income or you might have taken a rollover distribution from a 401k or an IRA you had set up before. You could get the funds to a cryptocurrency platform like Gemini or Kraken to buy and sell virtual currency. The gains and losses will not be subject to tax, while the funds remain in the account, but when you pull any funds out of the account…that’s when 100% of the distribution will be taxed. If you bought Bitcoin in the account for $5,000 and sold it for $5 million, it’s not taxable when you sell it, like it would have been in your previous taxable account. But the full $5 million is subject to income tax when you pull it out in the form of periodic or lump-sum distributions.
3) A non-taxable post-tax account. This is commonly referred to as a Roth IRA. These funds have already been subject to both payroll taxes AND income taxes. So they are considered after-tax funds. But the income created by these funds will not be taxed, neither during the trading period nor the distribution period, provided the income is the type of income that is consistent with the tax-exempt status of the entity. Namely, passive income. Sticking with our previous example of buying Bitcoin at $5,000 and selling it at $5 million, it’s not taxable when you sell it and it’s not taxable when you pull out the $5 million.
All 3 types of accounts serve their purpose based on your objectives and the type of business activities with which you are involved.
- A taxable account. Maybe you have a normal savings account in US dollars, and maybe you have some money in another account. I know that PayPal and Venmo now allow virtual currency trading in their accounts.
- The second is a traditional IRA (not a ROTH), or a 401k. These funds will only be taxed when you pull the money out.
- And finally the ROTH IRA, these funds would have been taxed before you put the money in, but any gains in the account and any distributions will not be taxed.
So that’s it for part 2 of our series, Cryptocurrency Taxes: Know What You Don’t Know – 3 Rules of Three. In the next episode, we will cover the three types of legal entities that can be utilized to optimize your Cryptocurrency business practices and minimize your tax liability and expense. This is Kelly Coughlin at EverydayCPA. Thanks for watching.
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