Delving Into Foreign Currencies? How Can You Preserve Capital While Maintaining Growth?

Whether you no longer trust the safety (or veracity) of the funds available in the U.S. stock market, or are simply looking for a way to parlay a modest initial investment into an early retirement, you may be searching alternative investments, particularly those in foreign markets. Investing on the foreign exchange market (forex) -- that is, trading one type of currency for another country's currency projected to increase in value over the short or long term horizon -- can often yield higher returns than more conservative bonds or mutual funds, although these investments also carry higher risks. Read on to learn more about forex investing and how you can preserve your initial investment while still seeking high yields. 

What research should you do before investing in the foreign exchange market? 

Because forex currencies can be risky investment vehicles that carry the risk of losing part (or all) of your initial investment, it's crucial to ensure you fully understand the details of forex investing before placing your first order. In addition to reading blog posts and books targeted to those who are still new to forex investing, one way to educate yourself is by tracking forex indicators. 

A forex indicator is a software program or other tool that can help point out patterns in forex trading prices and help stave off any potential losses down the road (while also helping you maximize gains). If you're already eyeing the yen, euro, or other form of foreign currency and just don't know whether you're ready to pull the trigger, a forex trend-following or trend-confirmation tool can use mathematical formulas (like the 50-day or 200-day moving average) to chart both where the price of this currency has been and where it is expected to head over the next few days or weeks.

Once you're already invested in one or more foreign currencies, you'll be able to use these forex indicators to determine whether you should sell soon (generating a short-term gain or loss) or hold the currency to generate a long-term gain or loss, which can mean different tax treatment. 

What are the potential tax implications of forex investing? 

The tax treatment of forex investments can be very complex. Not only are you investing in another country's currency (and therefore potentially incurring foreign tax liabilities), you're often doing so under the auspices of another tax-sheltered or tax-advantaged account. For example, the tax treatment of forex losses or gains in a self-directed Roth individual retirement account (IRA) can be very different from the treatment of losses or gains in a self-directed traditional IRA. The type of forex investment you're purchasing can also affect your taxes. 

In most cases, "spot" forex investment gains are subject to ordinary capital gains taxes, while options and futures orders are subject to a split tax rate. When you invest in forex options and futures, approximately 60 percent of your eventual gains (or losses) will be taxed at the 15 percent long-term capital gains rate, while 40 percent of the gains or losses will be taxed at the higher 35 percent short-term capital gains rate. 

One way to avoid this headache is to transfer your existing Roth IRA to a forex investment account, taking advantage of the post-tax funds deposited in your IRA to avoid paying taxes on any investment gains. However, there is another side to this coin; your losses won't be tax-deductible. 

On the other hand, if you use a traditional IRA for forex investing, you'll be able to deduct any "locked in" losses you experience or use these losses to offset future gains, reducing your tax liability for each year a loss is taken.