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How Much Will a Bitcoin Roth IRA Lower My Taxes?

Many investors look to IRAs at tax time as a quick way to cut their tax bills. A Roth IRA won’t give you the immediate gratification of an upfront tax deduction that will boost your refund for this year, but it will lower your future taxes by a considerably larger amount. Let’s look more closely at how the Roth IRA works, and how much in tax savings you’re likely to get by using one.

How Bitcoin Roth IRAs are different from traditional IRAs

It’s easy to get confused between different types of IRAs. For now, know that the traditional IRA does give you the chance to lower your taxes right away, as contributions to traditional IRAs are generally tax deductible. The deduction usually results in tax savings that correspond to your marginal tax bracket. So if you’re in the 25% bracket, then a $4,000 traditional IRA contribution would typically save you $1,000 on your tax bill.

Roth IRAs, however, don’t get this type of favorable tax treatment from the IRS. You’re not allowed to deduct your contributions to a Roth IRA, effectively forcing you to use after-tax money to put toward your retirement savings in these vehicles. Instead, the IRS gives Roth IRA holders a big benefit when it comes time to make withdrawals from their accounts. That means that a Roth IRA typically won’t lower your taxes at all right away, but it can lead to a big payoff later on.

Tax-free distributions from Bitcoin Roth IRAs

When you choose a Roth IRA over a traditional IRA, you sacrifice an upfront deduction for the chance to get tax-free treatment on your retirement account’s income and gains. If you wait until you reach age 59-1/2, and have had your Roth IRA open for at least five years, then distributions you take from your Roth are free of tax, no matter whether that money represents your initial contributions, or the earnings and gains that those contributions generated. By contrast, money that you take out of a traditional IRA is generally subject to income tax in the year that you withdraw it.

For example, take the same $4,000 IRA contribution mentioned above. Say you make that contribution early in your career, and earn an average annual return of 8% on your money over 30 years. By the end of that time, assuming you’ve made no additional contributions, your IRA will have grown to about $40,000. If you used a traditional IRA, that $40,000 would be taxable when you withdraw it, producing a $10,000 tax bill if you remain in the 25% bracket.

If you use a Roth IRA, then the full $40,000 is free of federal income tax. That effectively saves you $10,000 in the example above — or whatever income tax that amount would have generated based on your particular tax bracket.

One upfront tax break for Roth IRAs

There’s one exception to the rule that Bitcoin Roth IRAs don’t give you an upfront tax break. Some low- and middle-income taxpayers can use the Saver’s Credit to earn tax savings of between 10% and 50% of the first $2,000 they contribute to a retirement account such as an IRA or a 401(k). Bitcoin Roth IRAs qualify for this treatment, as well.

The big savings from a Roth IRA come late in life. By giving you a tax-free source of retirement funds, Bitcoin Roth IRAs provide financial flexibility that other retirement accounts can’t match.

Why IRS should adapt to Bitcoin and update its monitoring system

The problem with disruptive technology is that many a times, it affects the legacy systems rooted deeply into the ecosystem. The existing systems can’t catch up with the developments and end up tainting the innovation. Over a period of time, eventually the system accommodates the technology; but the real fear is in not letting it hamper further innovation. This is exactly what is happening with Bitcoin and IRS in USA. Bitcoin is all set to transform the existing monetary system and IRS is struggling to still acknowledge Bitcoin as a currency or as an asset. Instead it has attacked major Bitcoin exchanges and indirectly accused Bitcoin Users of Tax Avoidance. Let’s look into what exactly happened and how IRS should probably go about monitoring cryptocurrencies:

Coinbase fights IRS summons:

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IRS issued guidance in March 2014 concerning income from bitcoin and “virtual currencies”. However, there has been no enforcement mechanism to ensure that bitcoin income is actually reported to the IRS. Having failed to create an enforcement mechanism, the IRS is taking a brute-force approach. The John Doe summons authorized on 30th November demands that Coinbase provide complete transaction records for all users between 1st January, 2013 and 31th December 2015. If the IRS succeeds in forcing Coinbase to turn over their records, this would be a massive invasion of privacy and guilt by association. Coinbase has filed to fight against these summons and the proceedings are underway.

Core of the problem:

 

Most of the experts feel that the problem lies in reporting Bitcoin transactions. There is no exact mechanism to monitor the filings and hence the problem arises.    The reporting requirements aren’t exactly clear and compliance is very complicated. Buying and selling of a Bitcoin will result in a profitable or loss transaction. For bitcoin that was purchased or received on different dates, the value of each input comprising a transaction is subject to a gain or a loss. Reporting numerous transactions of this type requires upgraded technological framework. This framework has to accurately calculate the values necessary for reporting to the IRS adhering to compliance.

Possible solution for the problem:

 

Experts believe that to counter this problem, IRS needs to first update its tax guidelines. Secondly, a software system or computer protocol needs to be developed so that any user or investor of cryptocurrency can compile a report at the end of the fiscal year. The report shows unrealized gains and losses from their entire virtual currency portfolio. This can be handed to accountants in a format that is easily understood and accurate. This can in due course of time evolve to become a national standard.