Question # 298: I have a question with regards to Zakat. If you have a 401K account which is sitting for a long time, how do you pay Zakat on it. Shall we deduct the tax from the total amount based on the tax bracket and pay 2.5% on the balance.
Bismi-llahi r-raḥmani r-raḥīm,
Assalamu ‘laikum warahmatullahi wabarakatuh,
All praise and thanks are due to Allah (سبحانه و تعالى), and peace and blessings be upon His Messenger (صلى الله عليه و سلم).
First of all, we implore Allah (سبحانه و تعالى) to help us serve His cause and render our work for His sake.
Shorter Answer: Retirement funds such as 401(k) and similar funds are Zakatable since the restrictions imposed by the tax system on the withdrawal do not negate the essence of ownership of the account holder. Hence, zakah is due on the sum of the employee’s own contribution and the portion of the company’s match that is “vested”, along with any gain or profits that have since been accumulated.
Zakah must be paid on these funds on an annual basis on the withdrawable/ accessible amount after deducting all prescribed penalties and taxes and administrative fees. It is to be noted that it does not mean that one has to withdraw the amount to pay Zakah on it, rather one should perform a theoretical calculation to come up with these numbers based on the following formula: Withdrawable amount – prescribed penalty – prescribed tax = Zakatable amount.
Some scholars suggest that since one does not have accessibility to the retirement funds at present, then instead of giving zakah annually, one may pay zakah for all the previous years when he/she withdraws his funds (either upon retirement or earlier than that by paying the relevant penalties and taxes); but, in which case, one should keep accurate records so he can properly discharge the Zakah for all the previous years. Also please refer to Question # 402: Permissibility of Investment in 401(K) Plan.
Long Answer: For those not aware, in the United States, a 401(k) plan is the tax-qualified, voluntary retirement savings plan. Under the plan, retirement savings contributions are provided by way of deduction from the employee’s paycheck before taxation; the employer may contribute to the plan by matching or partially matching the contribution of each employee. The Internal Revenue Code imposes severe restrictions on withdrawals of tax-deferred contributions, while a person remains in service with the company and is under the age of 59½. Any withdrawal that is permitted before the age of 59½ is subject to a penalty tax (on top of the ordinary income tax that has to be paid). However, many plans do allow employees to take loans from their 401(k) to be repaid with after-tax funds at predefined interest rates. Nevertheless, the employee can opt out of making contributions to the 401(k) plan, if he/she does wish to participate.
Retirement funds such as 401(k) and similar funds are Zakatable like any other Zakatable items. Since these are owned and managed by the account holder, the restrictions imposed by the tax system [on the withdrawal] do not negate the essence of ownership and do not make such funds like what is called in Fiqh “al Mal al Damar” which is money you lost and you do not know where it is. [In fact,] the employee has certain authority on management and withdrawal, even with a penalty. This money is subject to Zakah because the restrictions do not invalidate account holder’s ownership or his/her ability to use, they are restrictions to “wise up” only or to force one not to misuse a tax relaxation. (Fatawa On Zakah by Dr. Monzer Kahf) Hence, contemporary scholars have stated that plans like the 401(k) are to be considered as part of one’s assets and Zakah should be calculated on them annually, [as long as the total amount (along with any other Zakatable asset) meets the nisab (minimum threshold for Zakah).]
As discussed above, the 401(k) plan is made of two parts:
- Employee’s Contribution (the money contributed by the employee): The employee owns 100% of this amount even if he has to pay penalties and taxes for withdrawing the money before retirement age.
- Company Match: (the money contributed by the company on behalf of the employee): The Company matches the employee’s contribution up to a certain percentage. Ownership of the company’s contribution is usually transferred to the employee over a period of time as determined by the company known as “vesting”. This schedule usually depends on length of employment and varies from company to company.
Hence, Zakah is due on the sum of the employee’s own contribution and the portion of the company’s match that is “vested” (i.e. the amount of the company’s contribution that the employee has acquired an ownership of and can withdraw along with his own money); [along with any gain or profits that have since been accumulated.] (Mufti Ebrahim Desai, askimam.org)
Regardless of whether or not the account holder has reached the age of maturity, Zakah must be paid on any pension plan, 401(K) or the like, on an annual basis on the withdrawable/ accessible amount (the portion of the full account balance each year as it increases) after deducting all prescribed penalties and taxes and administrative fees. [In other words, since zakah is only mandatory on assets you have complete ownership and possession on, you estimate the amount of money you will walk away with if you immediately withdraw it from the fund.] It is to be noted that it does not mean that one has to withdraw the amount to pay Zakah on it, rather one should perform a theoretical calculation to come up with these numbers, so as to be able to calculate Zakah. Hence, Zakah must be calculated based on the following formula: Withdrawable amount – prescribed penalty – prescribed tax = Zakatable amount. (Fatwa of Dr. Main Khalid Al-Qudah, Member of the Fatwa Committee of Assembly of Muslim Jurists in America) Hence, the Zakah on these “restricted” funds can be paid from other sources and one does not have to withdraw the fund actually.
[On the other hand, as for deferment of payment of Zakah, some scholars suggest that since one does not have accessibility to the retirement funds at present, then instead of giving] …Zakah annually by calculating the value of his 401(k), [one may pay] Zakah for all the previous years, when he/she withdraws his funds (upon reaching retirement age or earlier than that by paying the relevant penalties and taxes). [However,] practically, it would be easier to discharge the Zakah due on an annual basis. However, if one wants to give Zakah when he withdraws the funds from his 401(k), he should keep accurate records so he can properly discharge the Zakah for all the previous years. (Mufti Ebrahim Desai, askimam.org) [Furthermore,] if one actually gets less than the amount calculated (because of tax and penalty), one can recalculate past years Zakah as long as you did not pay it yet.
Allahu A’lam (Allah (سبحانه و تعالى) knows best) and all Perfections belong to Allah, and all mistakes belong to me alone. May Allah (سبحانه و تعالى) forgive me, Ameen.