It is a very common practice among the Muslim community for individuals to pay their zakāh during the month of Ramadān. Every year during this time there are several questions regarding what assets are subject to zakāh, how to calculate how much one owes, who zakāh may be given to, and almost everything else related to zakāh. One of the most common questions that is asked is, “Do I have to pay zakāh on my 401 (k) plan?” The short answer is yes.
First of all it is important to understand that it is not necessary to pay zakāh on every type of wealth a person owns. For example, a person’s basic personal needs (al-ḥawā’ij al-aṣliyyah) are exempted. This refers to a person’s house, furniture, clothing, car(s), or any other personal belongings that were not purchased with the intention of resale. Only those assets that have the potential of growth and increase are subject to zakāh. Wealth that is subject to zakāh is classified into five categories:
- Cash – regardless of what type of currency it is such as dollars, euros, rupees, riyals, or pounds in your hand, checking account, saving account, stocks, investments or loans.
- Gold and silver – regardless of what form it takes such as coins, raw nuggets, bars, jewelry worn or not, and decorative pieces.
- Trade goods (merchandise) – refers to any non-monetary (not cash, gold or silver) purchased with the intention, at the time of purchase, of resale.
- Livestock – camels, cows and sheep that are meant for grazing
- Agricultural output.
Conditions of Zakātable Assets
An asset is technically subject to zakāh if it meets the following seven conditions:
- Unrestricted/Complete Ownership (al-milk al-tām) – the asset must be owned completely by the individual in such a way that they may derive benefit from it and transact in it. This requires that in addition to being in their ownership, the wealth is also in their possession and subject to their discretion. In simpler terms they own it and can benefit from it.
- Potential of growth – The asset must have the potential to grow and increase.
- In excess of basic personal needs – The asset must be in excess of one’s basic personal needs (al-ḥawā’ij al-aṣliyyah) such as a house, clothing or car.
- Reaches the niṣāb – The niṣāb is the minimum amount of wealth that makes zakāh obligatory. A person who owns the niṣāb or more is considered, according to the sharīʿah, to be wealthy. For example, the niṣāb of gold is 87.48g ($3,563.06 as of 5/29/2017) and the niṣāb of silver is 612.36g ($342.92 as of 5/29/2017).
- One lunar year passes over it – It is necessary for one lunar year to pass over the ownership of the asset.
- In excess of any debts
Basics (Very) on 401 (k)
A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. The employee decides how much they want to contribute, and the employer puts the money into an individual account on the employee’s behalf. The investment happens through payroll deduction: the employee decides what percentage of their salary they would like to contribute. From then on, that amount comes straight out of the paycheck and goes into the account automatically. The funds in the account can be invested in a number of different stocks, bonds, funds or other assets, and are not taxed on any capital gains, dividends, or interest until they are withdrawn. As an incentive many employers offer to match a certain percentage of the employee’s contribution.
A 401 (k) has a number of restrictions and regulations that make accessing the money in the account before the age of retirement very difficult. Typically, a person will not have access to their funds until the age of 59 ½ and early withdrawals result in taxes and a 10% penalty.
Zakāḥ on 401 (k)
In order to determine if the funds in a 401 (k) are subject to zakāh we have to analyze and see if they fulfill the conditions mentioned above. Based on how a 401 (k) is structured, it is clear that the money invested in the fund by both the employee and employer along with any gains/profits is owned by the employee. Since it is wealth owned by an individual, it will be subject to zakāh, as long as the other conditions are met.
However, since funds cannot be withdrawn from the plan until the age of 59 ½ without incurring taxes and penalties, zakāh will not be due on it until one has unrestricted access to the money, and at that time zakāh will be owed for all of the previous years. This is similar to the case of money loaned to an individual. If a person gives a loan to an individual that is either documented or acknowledged, then the lender has to pay zakāh on that amount for each year of the loan, payable when the borrower repays it. For the sake of ease and simplicity, most scholars advise individuals to pay zakāh on the total value of the plan each year. It is very difficult to go back and calculate how much one would owe each year for the past ten, twenty, thirty or even more years.
In order to calculate how much zakāh is owed, add the amount of money in a 401 (k) to one’s other assets (cash on hand, balance held in both savings and checking accounts, merchandise, monetary value of gold and silver, etc.), subtract liabilities, and pay 2.5% of the remaining balance, as long as it reaches the niṣāb.
For example, a person’s 401 (k) plan is worth $10,000 and they have another $5,000 in cash, $2,000 in a checking account, $5,000 in a savings account, and $1,000 worth of gold, The total value of zakātable assets is $23,000. They will owe 2.5% of $23,000 in zakāh, which is $575.
What Amount is Subject to Zakāh?
There is a discussion among contemporary scholars regarding what value a person pays on if they are paying zakāh on their 401 (k) every year. Do they pay on the entire value of the plan, or can they subtract the taxes and penalties that they would incur if they were to withdraw early. Mufti Abdurrahman Mangera and Shaykh Faraz Khan are both of the opinion that the taxes and penalties should not be deducted and one should pay zakāh on the total amount in the fund. Shaykh Salah Al-Sawy is of the opinion that you can subtract the taxes and penalties. A person should follow the opinion of a local scholar or imam whose knowledge and expertise they trust and feel comfortable with.
Clarification Regarding Complete Ownership
Oftentimes an argument is made that the ownership of the wealth in a 401 (k) is not complete or unrestricted since a person cannot access funds without incurring taxes and penalties, and therefore should only be subject to one time zakāh when it is time to cash out without penalty. However, the reality is that a person ultimately has control and access to the money in the fund and the ownership should be considered complete for several reasons. A 401 (k) is voluntary; a person voluntarily invests a portion of their paycheck into a fund which is matched up to a certain percentage by their employer. In addition to that the entire purpose of the fund is for the money to grow through gains and profits. The investor also has access to funds, albeit through incurring taxes and penalties. Ultimately, the individual is in control of the funds and is definitely benefitting from them, which is considered complete ownership.
Allah knows best.