What Is Crypto Staking and How Does It Work?

Crypto staking lets investors generate potential rewards and interest on their investments. Learn more about the requirements.

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Nicole Sanders
Principal Software Engineer, Blockchain Expert

Crypto staking is a way for cryptocurrency investors to passively generate rewards or interest for owning crypto. If you have crypto assets and want to increase your holdings, staking could be one strategy that will allow you to do so.

Below, learn more about crypto staking.

What is crypto staking?

Crypto staking is the process of temporarily locking cryptocurrency in a specified wallet to activate software and become a validator for that blockchain. Validators offer input on the true state of transaction history and records, in addition to creating new blocks, and rewards are given in exchange for helping to secure the network.

Staking cryptocurrency is an essential part of maintaining a proof-of-stake (PoS) blockchains like Ethereum 2.0. It’s similar to mining in proof-of-work (PoW) blockchains like Bitcoin. Both processes serve as a consensus mechanism to validate transactions on their respective blockchains.

PoS networks rely on the economic incentive of a user’s staked funds to efficiently provide network security as opposed to the processing power used in PoW. 

Since PoS requires far less energy and leaves a smaller carbon footprint, it’s considered an environmentally-friendly alternative to its PoW counterpart.

How does crypto staking work?

There are two general ways to stake your crypto:

  • Independent Staking. You become an independent validator and stake your assets directly. Thus, you will receive all the rewards.
  • Staking pools. You and other crypto investors lock up your funds together. You aren’t a direct validator, but you delegate your coins to a pool, and receive a portion of the staking rewards minus the pool’s fees.

Requirements

PoS blockchains require an investor to own a minimum amount of a crypto asset to become a validator and stake independently. Ethereum is a well-known example. To stake Ethereum independently, you need to own at least 32 ether (ETH), which is a significant barrier to entry. 

Staking pools tend to require platform fees, which will reduce your returns slightly.

For example, if you have 3 ETH worth $10,000, you don’t have enough to become a validator yourself. You can lock up your ETH in Ankr, a staking pool, for six months. The platform offers a 5% annual yield net of fees.

Over the next six months, you could accumulate crypto rewards of 0.075 ETH worth $250. At that point, you can continue to stake your funds and earn rewards, or withdraw the funds to access your earnings.

Is crypto staking profitable?

Crypto staking has potential to be a lucrative opportunity for crypto investors. It’s possible that yields could reach higher levels than you’d receive from fiat currency in a traditional or online savings account.

In September 2021, the top ten assets' yields on Staking Rewards ranged from 5% to 14%, with most hovering around 6% annual percentage yield (APY). In comparison, you’d expect roughly 1% APY on a high-yield online savings account. 

A decent staking yield on your cryptocurrency could add up. For example, if you were to stake 5,000 Cardano (ADA) worth $10,000 and receive 6% APY, you’d earn roughly $1,236 worth of ADA over the next two years.

If you intend to buy and hold a digital asset long term, you could consider staking returns as part of your investment strategy.

Can you lose money staking crypto?

Crypto staking could help you make some extra passive income and grow your portfolio, but with every investment strategy there’s a risk of lost profit.  

Some of the most significant risks are:

  • Market risk. One of the primary drawbacks to staking your crypto is the potential lockup period. You can’t sell your crypto during this time, but you’re still vulnerable to drops in the price. If you stake a coin to get a 6% yield, but the value drops by 30%, you’ll have a significant loss.
  • Liquidity risk. If you stake digital assets with less liquidity, you may have difficulty selling them, which could prevent you from accessing your staking profits.
  • Smart contract risk. The smart contracts that enable some staking pools aren’t infallible. They’re products of their creators, subject to human error; imperfect coding could lead to vulnerabilities, hacks, and loopholes.

What are some top staking coins?

Staking isn’t possible with every cryptocurrency. Remember, you’re serving as a validator for a PoS blockchain.

As a result, staking isn’t possible for cryptocurrencies on PoW blockchains; for example, you aren’t able to stake Bitcoin.

Some of the most popular cryptocurrencies you can stake are:

  • Ether (ETH)
  • Cardano (ADA)
  • Polkadot (DOT)

Ether (ETH)

ETH is the cryptocurrency for Ethereum, a popular foundational blockchain for most decentralized finance (DeFi) transactions. 

Since the release of the ETH2 upgrades to the Ethereum blockchain, crypto investors can become validators and stake their ETH to receive rewards. To do so, you must own at least 32 ETH. Investors must also wait until the ETH2 updates are complete to withdraw their staked ETH. According to Ethereum’s estimates, this is expected to occur in the second quarter of 2022.

As of September 2021, approximately 7.79 million ETH are staked between 235,595 validators; Ethereum’s yield is 5.6% APY.

Cardano (ADA)

Cardano is a PoS blockchain network with a native cryptocurrency called ADA. One of the main selling points of staking ADA is Cardano’s lack of lockup period.

Staking Cardano provides an annual yield of  approximately 4.6% as of September 2021.

Polkadot (DOT)

Gavin Wood, one of Ethereum’s co-founders, launched the Polkadot blockchain in 2017. Its primary selling point is that it facilitates cross-chain communication. Data and tokens can be transferred across public, open, permissionless blockchains as well as private, permissioned blockchains.

Staking Polkadot’s native token is a potentially attractive opportunity because of its unusually high yield. As of September 2021, crypto investors can earn roughly 14% APY by staking DOT, though there is a 28-day lockup period.

How do you start crypto staking?

To start staking crypto, you’ll need to choose a cryptocurrency that is part of a PoS blockchain. 

Next, prepare a crypto wallet to store the asset. Alternatively, you can work with a centralized platform that supports staking such as Coinbase or Gemini.

At this point, you can acquire the asset you wish to stake. Make sure you meet the minimum quantity necessary to stake that asset.

Then, visit the platform of that cryptocurrency or the centralized crypto exchange you’re using to begin.

How is crypto staking taxed?

There’s no specific Internal Revenue Service (IRS) guidance on staking. However, the IRS guidance on mining supports that there could still be tax implications for staking activities because of its similarity to mining. 

If you follow and apply IRS Notice 2014-21, the guidance on mining income, a staking reward is taxable as ordinary income at its fair market value on the date you receive it. 

If, at a later date, you sell the crypto received as a staking reward, you’ll owe capital gains tax on any increase in value. The gains will be short-term or long-term, depending on whether your holding period is less than or greater than a year. Short-term gains are subject to ordinary income taxes, while long-term gains receive discounted rates.

For example, say you have 5 ETH worth $20,000. You stake the assets in a staking pool that pays 7% APY net of fees. That year, you generate .5 ETH worth $1,450 and then take your assets out of the pool.

After six months, you decide to sell your .5 ETH when its value has gone up to $1,800.

Under this scenario you should include the original staking reward—the sum of $1,450—in your gross income for the year. It would then be taxable at your ordinary income rate, similar to how normal paycheck funds are taxed.  

Additionally, you have a $350 capital gain for the increase in value of the .5 ETH prior to the sale—$1,800 minus $1,450. Because your holding period was less than a year, it’s subject to ordinary income tax rates.

How TaxBit can help

Keeping up with all the paperwork and reporting regulations for digital asset transactions can be laborious and time-consuming. The more complex your crypto portfolio becomes, the more complicated your tax liabilities can get.

TaxBit helps track your crypto transactions, and fills out your tax forms automatically.

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