.png "6 Ways to Invest in Cryptocurrency (Including Tax-Friendly Options)")
Every investor should build a diversified portfolio that helps protect you from market downturns. Owning crypto or any alternative investment can be a good idea when you limit your exposure to a small percentage of your overall portfolio; however, it's still a highly speculative and volatile asset.
You’ve probably noticed that the use of various cryptocurrencies is exploding! It seems like new coins and blockchain technologies are getting created every day. So, if you’re eager to learn more and invest in crypto but aren’t sure where to start, keep reading.
This post will review what cryptocurrency is, various ways to buy it, tax rules for crypto profits, and a strategy to start stacking coins. You’ll learn six ways to invest in crypto, including some clever, tax-advantaged options for avoiding capital gains taxes altogether.
What is cryptocurrency?
Cryptocurrency or crypto is digital money, known as tokens or coins, that you can use to buy goods and services or hold as an investment. Bitcoin is one of the most well-known cryptos, with a total value of about $1.1 trillion in December 2021. Still, there are thousands of alternative or altcoins, such as Ethereum, Solana, and Polkadot. The total value of all cryptocurrencies is about $2.6 trillion.
To understand how cryptocurrencies work, you need to know something about their underlying technology, which is a blockchain. There are different blockchains in use today, but their purpose is to verify transactions and store data in a secure, open ledger that anyone can see.
Blockchains are decentralized databases spread across many computers all over the globe. No one person or organization owns or manages public blockchains, making them difficult for hackers to manipulate.
Blockchain technology was developed for Bitcoin; however, other crypto networks, such as Ethereum, are also powered by blockchains. Also, there are many other uses for blockchain technology besides cryptocurrencies. They include smart contracts that automate the terms of agreements, recordkeeping for assets like real estate, and supply chain management.
To sum up, a blockchain is a distributed database with many uses, including powering cryptocurrencies.
Why do people use cryptocurrency?
If you wonder why people are investing so much money into crypto right now, there are various reasons. Many crypto supporters, including me, believe digital currency is the future of money.
While blockchain transactions are fully transparent, crypto is anonymous. That means you can buy, sell, and exchange it without revealing your personal information or identity. Crypto transactions are peer-to-peer, removing banks as middlemen who control the money supply.
While blockchain transactions are fully transparent, crypto is anonymous.
Many people buy crypto because they think it will increase in value despite its volatility. Bitcoin was trading around $20,000 in December 2017, hit an all-time high of $69,000 in October 2021, and is now bouncing around $48,000.
If the crypto roller coaster ride scares you, there’s a special crypto class called stablecoins pegged to specific assets, such as the US dollar. That gives you a way to own digital currency without any price volatility.
Bitcoin is a unique cryptocurrency because it’s hard-coded never to have more than 21 million coins created. And more than 18 million have been mined to date. Many people buy and hold Bitcoin because they believe its limited supply will cause the price to rise over time. This strategy is known as HODLing, which stands for “hold on for dear life.”
How do you buy cryptocurrency?
To buy cryptocurrency, you must have a wallet, which can be an online app or offline hardware device, to store it. If you use an exchange, such as BlockFi, Crypto, Gemini, or Coinbase, it’s as easy as opening an account, transferring your dollars, and making crypto purchases. They act as an investing platform and a “hot” online wallet. However, you can move your crypto into a “cold” offline wallet at any time for added security.
How is cryptocurrency taxed?
Crypto is taxed just like any other asset, such as stocks and mutual funds, where you must pay capital gains tax when you realize a gain. For example, if you buy $100 of crypto and sell it for $150, you must pay tax on your $50 profit.
Also, when you buy something with crypto or trade crypto that’s increased in value, it’s a taxable event. Let’s say you bought a bitcoin for $20,000 that’s now worth $50,000, and you use it to buy a car. You’d have a $30,000 capital gain to report.
Other taxable events include:
- Receiving crypto as payment for a service or mining it.
- Lending crypto and receiving interest payments.
- Staking crypto and earning interest or rewards.
So buying and holding crypto isn’t a taxable event. You only owe tax when you sell, spend, or trade crypto that’s risen in value, or you get paid interest on crypto you own. If you sell crypto for a loss, it can offset your gains, up to annual limits, just like other assets.
What are cryptocurrency capital gains taxes?
Capital gains tax rates depend on your tax filing status, income, and length of time you own an asset. If you own a coin (or other assets) for fewer than 365 days and sell it for a profit, you owe short-term capital gains tax, which equals ordinary income taxes. Today’s tax brackets range from 10% to 37%, depending on how much you earn.
However, if you own a coin for longer than a year, you owe long-term capital gains tax, which ranges from zero to 20%, depending on your income. So, holding assets for longer than a year is a wise strategy for cutting taxes, especially if you’re a high earner.
Another smart way to avoid capital gains tax on crypto is owning it inside a tax-advantaged account, which we’ll cover in a moment.
Crypto exchanges must file form Form 1099-K for clients with more than 200 transactions and more than $20,000 in trading during the year. And you must report crypto gains and losses on Form 8949opens PDF file .
Taxable options to invest in cryptocurrency
Here are three popular ways to buy cryptocurrency that will trigger capital gains tax when you sell, use, or exchange it.
- 1. Crypto exchanges
As I mentioned, buying crypto through an exchange is an easy and popular way to buy and sell it. Just open your account and fund it, and you can buy just about any coins you like and keep them in a handy digital wallet.
2. Crypto savings accounts
Many crypto exchanges allow you to earn interest on specific coins. Like bank savings, you make a deposit, the institution lends it out, and pays you interest. You can receive earnings in crypto of your choice and at significantly higher rates than a regular bank.
Right now, you can earn these impressive interest rates on your crypto savings, depending on your balance and the duration you lock it up without being able to make a withdrawal, such as for one or three months.
- BlockFi pays up to 9% APY on USD Coin (USDC), Gemini dollar (GUSD), Paxos (PAX), Dai (DAI), 5% on Ethereum (ETH), and 4.5% on Bitcoin (BTC).
- Gemini pays approximately 8% on Gemini dollar (GUSD), TerraUSD (UST), and USD Coin (USDC), 1.76% on Ethereum (ETH), and 1.49% on Bitcoin (BTC).
- Coinbase pays up to 5% on Cosmos (ATOM).
- Crypto pays up to 10% on USD Coin (USDC), 5.5% on Ethereum (ETH), and 4.5% on Bitcoin (BTC).
Unlike a regular bank, your money in crypto exchanges and savings isn’t FDIC insured up to certain limits. You could lose your crypto deposit if the institution fails. However, some crypto platforms offer insurance against losses, so be sure to read the fine print.
3. Crypto-rewards credit cards
If you’re not sure you want to buy crypto or stablecoins, there’s another way to earn crypto without risking your own money: using a crypto rewards credit card. You earn crypto on your spending or points to convert to cryptocurrency.
The BlockFi Rewards Visa® Signature Credit Card has no annual fee and earns 3.5% back in Bitcoin during the first three months and an unlimited 1.5% back after that. Your rate bumps to 2% if you hit $50,000 in annual spending.
If you want to earn other cryptocurrencies, the Venmo Credit Card pays cashback you can redeem for Bitcoin, Ethereum, Litecoin, or Bitcoin Cash. You can earn 3% on a top spending category of your choice, 2% on a second category, and 1% on all other purchases.
Tax-friendly options to invest in cryptocurrency
Here are three clever ways to buy cryptocurrency that don’t trigger capital gains.
- 1. Crypto Individual Retirement Accounts (IRAs)
Most investment platforms, such as Vanguard and TD Ameritrade, don’t support crypto trading, so you need a self-directed IRA that offers it. Using a crypto IRA is a smart way to buy and sell crypto because you never have to pay capital gains tax!
With a traditional IRA, your contributions are tax-deductible, and you pay ordinary income tax on amounts withdrawn in retirement. Contributions are taxable with a Roth IRA, but withdrawals (including all investment growth) are entirely tax-free in retirement.
Bitcoin IRA is the oldest and largest cryptocurrency IRA company. It allows you to earn up to 6% APY, invest in Bitcoin, many altcoins, and even physical gold. So, if you want to diversify your IRA with precious metals, it’s a great option. Another company, BitIRA, says it’s the most secure crypto IRA with a fully-insured cold wallet storage solution.
For 2021 and 2022, the annual contribution limit for a regular or crypto IRA is $6,000 or $7,000 if you’re over age 50. Anyone with at least that much earned income is eligible for a traditional IRA; however, there are annual income limits to qualify for a Roth IRA.
2. Crypto Coverdell Education Savings Accounts (ESAs)
A Coverdell ESA is a great way to save for a child’s education, from kindergarten through graduate school. And yes, you can open a self-directed ESA and invest in crypto. Check out Directed IRA, where you can buy over 20 cryptocurrencies, including Bitcoin, Ethereum, and Litecoin.
Contributions to a Coverdell get taxed, but withdrawals are tax-free if you use them for qualified education expenses, such as tuition, books, equipment, and supplies. There’s an annual income limit to qualify for Coverdell contributions, and you can save up to $2,000 per student per year.
3. Crypto Health Savings Accounts (HSAs)
Using a health savings account to save for current and future healthcare expenses is one of the best financial moves you can make. They give you the following three tax benefits:
- Tax-deductible contributions.
- Tax-free investment growth.
- Tax-free withdrawals (if you spend them on qualified healthcare expenses).
While you typically can’t invest your HSA balance in crypto, self-directed accounts allow it, such as Directed IRA. Note that to qualify for an HSA, there’s no annual income limit, but you must be enrolled in a high deductible health plan.
For 2021, you can contribute up to $3,600 or $7,200 if you have a family health plan. The limit increases slightly for 2022 to $3,650 or $7,300. And if you’re over age 55, you can contribute an additional $1,000 per year.
Should you invest in cryptocurrency?
Whether you should invest in crypto depends on various factors, including your risk tolerance, comfort with or knowledge of the technology, and retirement time horizon. Remember that all crypto is highly speculative and volatile.
My best advice is to maintain a diversified portfolio that insulates you from market downturns. If you want to own crypto or any alternative investment, make it a small percentage of your overall portfolio, such as no more than 5%. Limiting your exposure allows you to profit from the upside without risking too much of your financial security.
What questions do you have about cryptocurrency? Leave me a voicemail at 302-364-0308 or email me at money@quickanddirtytips.comcreate new email.