How to calculate Zakat on 401(k)s?

The basic principles of Islam are development, economic justice, and social justice, and Zakat is the main building block for ensuring social and economic justice exists in the society. Zakat is due on wealth that is expected to grow such as cash and investment assets. Since 401(k) plans are assets-owned, they are zatable, you will owe zakat for each year you owned nisab.

To calculate zakat, add the employee’s contribution and the vested employer’s contribution, and deduct any penalties, taxes, and administrative fees to get the zakatable amount. Multiply 2.5% (zakat rate) by the zakatable amount to get the zakat due on the 401(k) balance.

According to Islam, giving to charity is considered proof of faith, and withholding your charitable contributions is a serious offense. As an obligation on all Muslims, the act of giving offers inner satisfaction to the giver. Also, by giving up part of their wealth, donors get a feeling of inner peace by knowing that only those funds on which zakat has been paid are halal for appropriation.

Zakat Rules on 401(k)

According to the Shari’ah law, Muslims are prohibited from making money from interest, also known as Riba. They are also prohibited from making money from businesses that sell goods or services that are illegal for Muslims to consume such as pork, alcohol, and pornography. As a result, Muslims cannot make financial gains from trading in stocks of companies that trade in the prohibited items. This applies to 401(k) accounts, which invest in stocks and mutual funds of different companies, some of which may trade in prohibited products.

A solution to this problem is to create equitable compensation plans for Muslim employees. Employers should work with the financial institutions or brokerage firms managing their 401(k) plans to determine if the range of investment products offered meet the needs of Muslim employees. The employer should also work out an option where these employees can direct their investments in permissible funds. Some employers may also offer Shari'ah-compliant investment options to their Muslim employees to help them save for retirement while observing Shari’ah law.

Is 401(k) Liable for Zakat?

A 401(k) plan is liable for Zakat if the employee has full access to the account. This means that the wealth is unhindered and the investor is actively managing the fund. However, Zakat is not due until when you have access to the funds without restrictions and penalties. Some Muslim scholars differ on when to pay the 2.5% Zakat on retirement amounts such as traditional IRAs and 401(k) plans.

Here are some of the situations when Zakat is due:

• Rule of 55: If you have reached age 55 and you retire or leave your employer, you can withdraw the 401(k) funds without a penalty tax. In this situation, Zakat is paid on the amount you withdraw at 55. If Nisaab still exists in the account, you will still be required to pay Zakat for each subsequent year.
• 59 ½: If you are 59 ½, you can cash out without a penalty. You pay 2.5% on the amount made available to you.
• If the 401(k) account is inaccessible and there is a penalty for early withdrawals, you are not liable for zakat on the retirement savings.
• If you are not allowed to withdraw funds from the 401(k) plan, and instead forced to take a loan from the 401(k) fund, you are not liable for Zakat until the funds remain in your account for one year after disbursement. If the funds remain in your possession for one year, you are liable to pay 2.5% Zakat on the 401(k) loan.
• If you are allowed to cash out the 401(k) and pay the early withdrawal penalty before the required age, you must pay the 2.5% Zakat on the amount withdrawn at the time when the funds are made available to you.

How to Calculate Zakat on 401(k)

When calculating how much Zakat you owe on your 401(k), you should consider both the employee’s contributions and the employer match (if the employer matches your contributions). 

The employee’s contribution represents the portion of 401(k) contributed by the employee, and 100% owned by him or her. In contrast, the employer’s match is the portion of 401(k) that is contributed by the company on behalf of the employee, usually a percentage of the employee’s contribution. The employer’s contribution in an employee’s 401(k) is transferred gradually to the employee in a process known as vesting. Zakat is calculated on the portion of the 401(k) that fully belongs to the employee i.e. the employee’s own contribution and the vested employer’s contribution.

For example, if Mustafa has contributed $20,000 to his 401(k) plan, and the employer has contributed $7000 to Mustafa’s plan, it means Mustafa now has $27,000 in his 401(k). However, based on the company’s vesting policy, only $5000 is vested, and the other $2000 will be fully vested in two years. Therefore, Zakat will be calculated on $25,000, which equals $625 (2.5%).

Is Zakat Payable Annually or When One Withdraws Funds?

Employees owe zakat on an annual basis since the restriction imposed on the funds such as income taxes and early withdrawal penalties do not affect the ownership of the 401(k) plans, and the funds therein. Zakat is calculated on the accessible amount in the retirement savings as follows:

401(k) account balance – penalties – administrative fees – taxes= Zakatable Amount (at nisab)

The above calculation does not mean that a 401(k) account holder should withdraw the amount to pay Zakat annually. Rather, he/she should do a theoretical calculation to determine how much they owe on their 401(k) balance. You can also pay Zakat on these funds from other sources.

Some scholars differ on when to pay zakat, with some scholars recommending payment of zakat every year. Other scholars argue that, since employees do not have access to the funds at present, an account holder may pay the zakat for all the previous years when he/she withdraws the funds at retirement, or when they opt for an early withdrawal by paying income taxes and penalties. They must pay Zakat on the net amount, provided that 12 lunar months have passed, and the balance reaches nisab.

Why Scholars Differ on If Zakat is Owed on 401(k)

Leading Muslim scholars have different options on Zakat due on retirement accounts such as 401(k) and IRA.

Scholars who are for the payment of Zakat on retirement accounts argue that account holders can pay it from the net value of 401(k) balance that they control after deducting taxes, penalties, and other fees if the account holder decides to withdraw the funds. In this case, the account holder holds absolute and undivided authority over the portion of funds in the account. Zakat is paid on the growing wealth after 12 lunar months have passed, provided the balance reaches nisab.

Arguments against paying zakat on retirement accounts hold that one does not pay zakat when the plan has restrictions and penalties on withdrawal of funds. They argue that these retirement accounts fail the test of zakatability i.e. undivided and absolute right to the ownership of assets. This test requires that the account holder exercises the free right of control over the property.

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