If you have not already, I recommend reading my Previous Columns on the topic of cryptocurrencies and taxes, as this column builds upon foundations established previously.
I like little better than the phrase “tax-deferred” or, even better, “tax-free.” That is why I am so excited to help you seriously consider whether you should open a self-directed Roth IRA to shelter your cryptocurrency profits from capital gains taxes and income taxes. Before we get to that, let’s talk a little about IRAs in general though.
When it comes to IRAs there are two main types that an individual can open: A traditional IRA or a Roth IRA.
Traditional IRAs, as we know them today, were established by dear Uncle Sam in 1974 as a way to offer individual tax payers the opportunity to take control of their own retirement. As corporate-managed, defined-benefit pension plans began to fail miserably, many retired people and others near retirement discovered their promised retirement benefits were missing in action due to poorly managed pension funds (I’m looking at you, American Airlines). As a result, IRAs became wildly popular.
The appeal of a traditional IRA is that a taxpayer can make investments into the IRA and defer the tax not only on the invested portion but also on any interest, dividends, or capital gains earned on that investment. Upon reaching retirement age, the taxpayer can start taking distributions, which are then taxable at the taxpayer’s current tax rate.
For example, let’s say you earned $55,000 last year and put $5,000 into an IRA. In the simplest terms possible, the IRS allows you to say you only earned $50,000, and you have successfully deferred the taxes on the $5,000 investment – good for you. Now, let’s say you invested all of that $5,000 in Tesla through your IRA because, let’s be honest, that new Roadster is pretty freaking awesome (0-60 in 1.9 seconds – seriously?). Tesla, of course, does amazingly well because why would anyone spend a half a million dollars on a Lambo when you can get a faster car from Tesla for $200,000. So when you reach retirement age in 30 years, that $5,000 investment is now worth $150,000. You begin taking distributions on that $150,000, and as you withdraw, it becomes taxable income to you. If you take $10,000 out, your taxable income is increased by $10,000 in the year distributed.
This all sounds pretty good, huh?
Well, there was one drawback. Typically, a taxpayer’s income increases over time and the taxpayer climbs into higher tax brackets with age. It is entirely possible, then, that one might defer taxes of 15% or 25% upon investing the money, only to be taxed upon withdrawal in a 40% tax bracket, so paying higher taxes on the distributions.
That may not be true for everyone but you, my friend, are a crypto investor and, by many accounts, destined to be a gazillionaire, so the odds are, you will be in a higher tax bracket someday when you start taking disbursements.
Wouldn’t it be cool if you could just go ahead and pay your 15-25% tax on the $5,000 before putting it into your IRA and then take the distributions upon retirement age tax-free? Well, you can. That is the Roth IRA, and although there are lots of complexities as to how much you can contribute annually (imagine a deep baritone voice in the background saying, “consult your local tax professional” as you read this sentence), it really is that simple. You pay the tax up front on the investment and get all the earnings on it tax free as retirement distributions. So, in the example we used above, you actually report all $55,000 of your earnings as taxable income and the $5,000 you put into your Roth IRA can grow exponentially with all related interest, dividends, and capital gains sheltered from any additional taxes upon distribution at retirement age.
In my opinion, there is simply no other way to go between the two options but to take the Roth IRA. It is truly a piece of legislation that offers an incredible long-term tax benefit to thrifty taxpayers.
You have repeatedly heard me refer to retirement age in relation to distributions from each of these IRA’s. Of note, though, you can take early distributions from either form of IRA, and that actually becomes an important point as we begin to talk about our ultimate goal of sheltering our crypto gains. Early distributions are any withdrawals taken from an IRA before the taxpayer reaches age 59 ½ and are subject to a 10% early withdrawal penalty and, in the case of the traditional IRA, taxes on the distribution as well. Some situations permit an early withdrawal without tax or penalty (like a first time home purchase), while other circumstances might incur tax liability on an early distribution even from a Roth. The rules are very complex and beyond the scope of what we are trying to accomplish here – refer back to the previously mentioned baritone voice.
By now, you may be starting to recognize why a Roth IRA might be a good tool for holding cryptocurrency investments. You pay tax on the investment, and later, when the crypto goes to the moon, you can take it out tax-free with, at worst, only a 10% penalty if you withdraw before age 59 ½. That is a lot cheaper than paying either long-term or short-term capital gains taxes on assets held by you personally.
The challenge becomes how to get the desired cryptocurrency into your personal Roth IRA.
Here, the “self-directed” component comes into play. Most IRAs today are self-managed but custodian held. “Custodian held” means a third party such as T Rowe Price, Fidelity, Vanguard, TD Ameritrade, or some other investment firm or brokerage is the custodian of your assets, and you send your fiat currency to them to fund your IRA. “Self-managed” means that you get to choose from the investment options they offer, but nothing else. With T Rowe Price for example, you may have decent variety but still be limited to only funds they manage. TD Ameritrade offers a wider selection including pretty much any stock, plus a variety of bonds and other securities as well but you can’t buy gold or cryptocurrency, for example.
Self-directed IRA’s give you more flexibility in that you can expand your investments beyond those approved by a custodian to encompass a much wider range of options including real estate, precious metals and now, thanks to the IRS declaring that virtual currencies are property (see my previous column What is The Cryptocurrency Tax Fairness Act of 2017 and how could it affect my Bitcoin transactions?), even Bitcoin and other cryptocurrencies.
Setting up a self-directed IRA can seem somewhat daunting, however. The easiest route is to open an account with a self-directed IRA custodian. As previously, you still send the investment to the custodian, but instead of being limited to a small handpicked list of investments, you can direct them to purchase whatever IRS-approved asset you desire. The drawback on this type of self-directed IRA is that custodial fees can get expensive.
A more challenging route is to establish a Limited Liability Company (LLC) that will house the investments. The LLC which is held (or owned) by members, has one lone member, the IRA, which is a separate legal entity from you, the investor. But, while the IRA “owns” the LLC, you manage it and direct the investment selections. This type of self-directed IRA is often referred to as a “checkbook control IRA” because you literally control the checkbook. The drawback here is up-front legal fees, plus it is easy to make a mistake that could void the tax-advantaged status of the IRA putting you in a precarious spot with Uncle Sam. Maintaining a clear divide between you the taxpayer and the IRA is critical. Again… baritone voice guy.
No matter which route you take, it is extremely important to understand that you should seek the advice of your personal tax professional in advance. Any misstep along the way can result in lot of dollars spent without accomplishing your ultimate goal of sheltering the gains on your crypto from taxes.
If you successfully establish a Self-Directed Roth IRA, purchase only one bitcoin through it and it does eventually reach a million dollars as so many predict, these steps could literally save you hundreds of thousands of dollars in taxes.
I will follow up soon with some recommendations on reputable companies that can help you establish a self-directed Roth IRA.
© Michael L. Collins
12 thoughts on “How to tax shelter gains on crypto currencies through a Self-Directed Roth IRA.”
Great article thank you. I set up an LLC no how do I set up the Roth IRA in it?
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The IRA actually has to be set up as the sole member of the LLC in order to work as a self directed IRA. I’d recommend consulting with your tax professional if you haven’t already. Best of luck to you!
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Just stumbled upon this blog and love it alread. As a CPA now working in Industry, it is nice to hear another CPA echoing what I had already been brainstorming on what to do with an old IRA set up when I was at a previous employer. I will definitely be transferring to a self-direct “checkbook control” IRA once I decide on which company I wish to use to set everything up. Have you made any progress in your research on companies that facilitate this process?
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Honestly, the best thing I have found is bitcoinIRA. They have a simple set up and seem to have favorable reviews. Thanks for the feedback. We CPAs can really help legitimize the community in my opinion.
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Great blog – thank you – Noble Gold, out in Pasadena, specializes in this too https://noblebitcoin.com/
Great article! I am in the process of establishing an LLC and checkbook IRA through Broad Financial and Madison Trust. I’m setting up a traditional IRA via a rollover of a portion of my TSP. waiting on the funds to be transferred at the moment.
Reason for not pursuing a Roth is I’m 61 and retired early so don’t have the earned income to invest in a Roth IRA.
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