For the inexperienced, bitcoin is the most prominent of several “virtual currencies”—money that exists only online and isn’t backed by any government. Released in 2009 by an unknown person or group going by the name, bitcoin is maintained by a decentralized network of computers, called “miners,” that process and verify transactions.
Like many investors, individuals have began seeking to buy bitcoins using their tax-deferred or tax-free retirement funds, such as a Solo 401(k) Plan or Roth Solo 401(k) Plan. However, when it comes to determine what transactions are permitted to be made with 401(k) plan funds, the Internal Revenue Code does not describe what a Self Directed Solo 401(k) Plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits disqualified persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of 401(k)s for accumulation of retirement savings and to prohibit those in control of 401(k)s from taking advantage of the tax benefits for their personal account.
One it issues that has continued to emerge with bitcoins is who should it be treated for tax purposes. Is a bitcoin a currency, or a capital asset, or should it be treated as a collectible? The problem is that the IRS has not offered any guidance as to how it will treat bitcoins for tax purposes. The determination of how bitcoins would be treated for tax purpose by the IRS is important in determining whether a bitcoin would be treated as a collectible, which is a type of asset that may not be purchased with a self-directed IRA.
In general, pursuant to Internal Revenue Code, a Solo 401(k) cannot Invest in certain collectibles, as defined below:
- Any work of art
- Any metal or gem
- Any alcoholic beverage
- Any rug or antique
- Any stamp
- Most coins
However, certain precious metals and coins are not treated as collectibles pursuant to Internal Revenue Code Section 408.
So how should a bitcoin be treated for tax purposes?
The lack of IRS guidance on the taxation of bitcoins has left many taxpayers and retirement investors perplexed as to the viability of bitcoins as a tax-efficient and/or IRS permitted transaction for retirement funds. Many tax practitioners have raised the following questions: When should bitcoin be considered a commodity, a currency or a capital asset for tax purposes? Are bitcoin transactions similar to barter? Is bitcoin subject to the same stringent tax rules as secret offshore accounts? And how will U.S. officials keep bitcoin, which is even more anonymous than cash, from being used to promote tax evasion or money laundering?
So far, the Internal Revenue Service hasn’t ruled on or addressed such issues directly. An agency spokesman released the following statement: “The IRS continues to study virtual currencies and intends to provide some guidance on the tax consequences” of transactions involving them. The agency is also “aware of the potential tax compliance risks posed by virtual currencies,”
Is bitcoin a currency or a collectible?
Bitcoin is usually described as virtual currency. That’s useful shorthand, but is it really money? And should it be taxed as if it is? Or is it a capital asset? How about a commodity? Or what about a collectible? Most commentators have viewed bitcoins either as a virtual type of currency or capital asset. However, the potential still exists that the IRS could argue that bitcoins do not satisfy the main functions of money and acts more like a stamp or other collectible than a currency.
The IRS says it is studying the matter but has yet to issue any guidance. Until it does, it is anyone’s guess how bitcoin should be taxed. Most users/investors have simply picked what is most beneficial to them when they file their 2013 returns. However, for retirement investors, it important to pause before determining whether to use a Solo 401(k) Plan to buy or sell bitcoins in light of the lack of IRS guidance as well as the steep penalties involved for engaging in a prohibited transaction. Accordingly, Solo 401(k) Plan investors should look to other types of IRS approved investments for their retirement funds until the IRS has provided more guidance as to how the bitcoin will be treated for tax purposes.