Is Zakat Owed on 401(k) Plans and Individual Retirement Accounts IRA?

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Is Zakat owed on retirement accounts, such as a 401(k)?

Yes, if one has full, free access to the account.

No, if the account imposes restrictions and penalties on one’s use and withdrawal of its funds.

Scholars, however, differ in their opinions on Zakat due on individual retirement accounts and defined-contribution pension accounts.

A Brief Overview on why scholars differ

Scholars who rule that one does not pay Zakat on an individual retirement account when restrictions and penalties apply to one’s withdrawal of money hold that this form of wealth fails the first test of Zakatability: undivided and absolute right of ownership (see What Requirements Qualify Wealth for Zakat?).

The scholars who prescribe paying Zakat on retirement accounts contend that one can pay it from the portion of its funds one does control, after deducting penalties, fees and taxes, were one to cash out the account.

The argument for no Zakat on restricted accounts

The Zakat condition of undivided and absolute right of ownership means one must exercise a free right of control over the property from which one pays Zakat. This has two requirements: (1) ownership and (2) exclusivity in that ownership.

Muslim jurists say the proof that one meets these two conditions over material wealth lies in one’s “power of disposition” over it. That is, can the owner freely use this material possession or its services, and can he or she without constraint choose to exchange it for another material substitute or consideration lawfully?

An owner who can do these two things with a material possession meets a secondary test for Zakat: the capacity to exercise legal authority over the use or exchange of a possession in a way that prevents any other person or entity from exerting a right to a legally competing entitlement to or over that same possession.

That owner’s exclusive right to use and dispose of the property, moreover, must exist potentially in perpetuity, meaning one’s unencumbered entitlement to it is open-ended in time.

In sum, the owner’s rightful hold over that wealth-form gives no one else a right to it. Nor does the owner need authorization from any other to use, access, or exchange it for a substitute possession or service.

So, when one’s right over a property is not absolute and undivided — for example, with something designated for one but not actually obtained by him or her — one has no obligation to pay Zakat from it. For this same reason, one pays no Zakat on something in lien or on a stolen possession.

For one to pay Zakat on wealth, one must have authority over the disposition of its nisab, it’s established minimum threshold amount, for the entire lunar year, or reasonable certainty that he or she can exercise that authority of disposition over it if desired (such as in the case of storing one’s gold with another party).

What is the argument for paying Zakat on restricted accounts?

Scholars who contend that one must pay Zakat on restricted accounts hold that one can, in fact, withdraw from a restricted account, even if one incurs a penalty, fees and taxes in doing so.

This means that one holds absolute and undivided authority over a designated sum of funds in the account.

Hence, one is obligated to pay Zakat on the growing wealth one potentially holds such authority over after a lunar year has passed on it, provided it reaches nisab.

These scholars (and this is the position of the Fiqh council of North America) put forward criteria for calculating Zakat on one’s restricted retirement accounts that we can represent in this formula:

Restricted Retirement Account Balance (B) – (minus) penalties (P) for withdrawal – (minus) fees (F) – (minus) taxes (T) = Zakatable Sum ZS (at nisab).

So: B – (P+F+T) = ZS (at nisab)
ZS x 0.025 (2.5%) = Zakat Due (ZD)

Can you give an example of paying Zakat from a 401(k)?

Zaid’s 401(k) account, which he has had for six years, holds a $100,000 balance (B). If Zaid withdraws his money, he will incur a 20% penalty (P) and pay a 25% tax (T) on the sum after penalty. Zaid’s final withdrawal sum after penalties and taxes will be $60,000. This is a Zakatable sum (ZS) because it exceeds nisab, and he has held it for a full lunar year. At his established Zakat Due Date (ZDD), Zaid pays 2.5% Zakat on it, which comes to $1,500.

B = $100,000
P (B x .2) = $20,000
B-P = $80,000
T = $80,000 x .25 = $20,000
ZS = $60,000
ZD x 0.025 = $1,500 (on ZDD)

What if one owes Zakat on a retirement account one can’t pay?

Zakat due on something that exceeds one’s capacity to pay it from that wealth is an argument against that wealth’s actual Zakat obligation.

In the case of restricted retirement accounts, this scenario (of a Zakat debt exceeding one’s capacity to pay it) only becomes a possibility if one adopts the position that Zakat comes due on restricted retirement accounts regardless of required authorizations, penalties for early withdrawal, and similar ownership-limiting conditions.

If one’s due Zakat payment on such an account exceeds what one has the means to pay from one’s available wealth, the Fiqh Council of North America has ruled that one pays on his or her due Zakat what one can, records the remaining deficit as an owed Zakat debt, and pays that Zakat debt (owed to Allah) as soon as one has the means to pay it. This opinion, moreover, holds that one may pay this Zakat debt off in increments.

However, as soon as one gains absolute and undivided authority over one’s account — to cash out at one’s discretion — any outstanding Zakat immediately comes due and one must pay it in full without delay.

Can you give an example of delayed Zakat payment?

In principle, one can pay Zakat in advance but cannot delay its due payment (see Can Zakat Payment Be Delayed or Advanced?).

Scholars who have ruled that Zakat comes due on restricted individual retirement accounts (IRAs) despite one not meeting their conditions of maturity have created two exemptions specific to this type of wealth holding: (1) They permit delay of its due Zakat payment with cause; (2) they allow one to pay the resulting Zakat debt in increments.

So, Maryam has a 401(k) account balance of $300,000 on which she wants to pay Zakat. She will not, however, have full and free access to her account for two years. She calculates that after penalty, fees and taxes, she can withdraw $180,000. This exceeds nisab. She calculates a Zakat payment of 2.5% from this amount, which comes to $4,500 owed as her Zakat at her Zakat Due Date (ZDD).

Maryam only has enough funds to pay $1,500 of her Zakat at her ZDD. She pays this amount in Zakat and records her outstanding Zakat balance as $3,000.

After a year passes, Maryam will recalculate her withdrawal amount in the same way and her due Zakat. Her Zakat payment for this (subsequent) lunar year came to $5,000. She can only pay $1,500 at her ZDD. She records her outstanding Zakat balance as $3,500. Added to her previous year’s Zakat debt from her individual retirement account, that comes to a total Zakat debt to Allah of $6,500.

In six months, Maryam will gain full and free access to her 401(k) account. She then pays $250 a month for six months on her Zakat debt, or $1,500. She calculates that she now owes $5,000 in Zakat debt. On the date she gains full and free access to her 401(k) account, Maryam pays her Zakat debt in full. Six months later, on her original ZDD, she calculates her total cash assets and pays Zakat on it at 2.5% in full.

Are all IRAs restricted like the 401(k) with the same Zakat rulings?

No. Some IRAs (like Roth IRAs) have their contributions taxed and because of this are penalty free; so they work differently than 401(k) and non-taxed IRAs. At age 59-and-a-half, after one has held a Roth IRA for five years, one has discretionary access to such an IRA without penalty or additional tax. Therefore, one counts its funds like other cash holdings and pays Zakat on their total amounts at the established Zakat rate on money of 2.5%.

In addition, before one’s Roth IRA, or similarly functioning retirement account, has matured to five years, one pays Zakat on one’s total amount of contributions as one would with any other monetary savings, subtracting the earnings of less than five years, adding it to your personal wealth, and paying Zakat on it at a rate of 2.5%.

Because one can pay Zakat in advance, one does not need to deduct the less-than-five-year earnings on a Roth (or similar retirement fund) and then count it as Zakat paid in advance on those cash assets when they mature and their Zakat allocation comes due.

Can you summarize the ruling on 401(k) and pension plans?

Zakat comes due on growing wealth that one has absolute and exclusive legal ownership of and which one can use and dispose of at will.

Therefore, the strongest opinion remains that one does not have a Zakat obligation on 401(k) plans, individual retirement arrangements (IRAs), and defined-contribution pension accounts to which one does not have direct access without penalty or based on other restrictive conditions.

When one’s accounts meet these criteria of complete ownership and control, they count as Zakatable, just like a debt owed to one that he or she can collect at any time. Once these free and clear accounts reach nisab, one must pay their Zakat yearly, at their due date at 2.5%.