In 1978 U.S. Congress passed a Revenue Act which included a provision that allowed employees to avoid being taxed on a portion of income that they decide to receive as deferred compensation, rather than direct pay. The provision was Internal Revenue Code Sec. 401(k). Today, 94% of private employers offer 401(k) plans.
A 401(k) plan is a retirement account that you can only access through an employer. You contribute a portion of your salary to the plan, and if you choose to put that contribution in a traditional 401(k), it isn’t taxed until you withdraw the money, allowing your investments to grow over time without being taxed. (Note: You will pay penalties if you take out the money before a set retirement age, as defined by the plan.) And, as an added bonus, many employers will match some of your contributions.
Traditional IRA – contributions are often tax-deductible (often simplified as “money is deposited before tax” or “contributions are made with pre-tax assets”), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted).It was introduced with the Employee Retirement Income Security Act of 1974 (ERISA) and made popular with the Economic Recovery Tax Act of 1981.
These are popular investments vehicles due to the tax advantages, but also place access restrictions and penalties on a person’s wealth. These tax shelters are usually created by the government to promote a certain desirable behavior, usually a long term investment for retirement so that people do not rely on the government when they are advanced in age.
Fundamentals of Zakah
Zakah is due on wealth that is liable to increase such as cash and sellable goods. It is exempted from personal items such as clothing, vehicles, etc, regardless of how much it may be. The reason behind this is because it is not liable to increase. For example, Muhammad has a personal research library containing $5000 worth of books and tools that he uses to landscape his backyard that are worth $5000. Even though he could sell these items in case he needed to, he has no intention to sell them and owns them in order to use them, thus they are not liable to increase in value due to the state they are in. Ali, on the other hand, owns a store in which he sells both books and tools. Assuming that he had $5000 worth of books in his store and $5000 worth of tools, he would have to pay Zakah on these items because this wealth is liable to increase. The difference between the two scenarios is that Ali purchased these items with the intention to resell them at a profit. Once he sells them, his product will convert to cash, which is zakatable, and most likely he will use that money to purchase more goods for sale. By buying products and selling at a profit, his wealth increases, whereas Muhammad’s books and tools are not intrinsically liable to increase in this way.
Another scenario which highlights financial decisions by individuals is the case of purchasing a car versus leasing one. Uthman and Zayd both have $20,000 each and want to get new cars. Uthman uses his $20,000 to buy a car but Zayd leases the same type of car for $2,000 per year for five years. When Zakah becomes due Uthman will not have to pay on the value of his car but Zayd will pay on the remaining cash every year from the original $20,000 he had, after his lease payments were made. After two years, Uthman could probably sell his car for $16,000 cash. If he did so, he would have to pay Zakah on that cash, but if he does not, then he does not need to pay Zakah. The reason why Zayd, who had originally had the same amount of money and now has the same type of car, has to pay Zakah and why Uthman does not is because Zayd’s cash is [potentially] productive, meaning he can invest it, whereas Uthman cannot because his wealth is stuck in the car he is using for personal reasons.
Investments are like Trade Goods
Many people will purchase something and hold that asset with the hope it will appreciate over time and they will be able to resell it at a profit. Even though they may not have the intention to sell it immediately, their primary purpose is for eventual resale. For example, Hasan purchases a vintage Ferrari vehicle for $100,000 and intends to keep it in storage for five years. He hopes that its value will double over those five years. Since his intention to purchase it was primarily for eventual resale, he will evaluate the market value of the vehicle every year and pay Zakah on it. This is because he would most likely be able to sell it at that market value on any given year.
Tax Shelters, Zakah Shelters, and Intention
When investing, a wise person considers choosing investments that result in the least amount of taxes possible. Taxes are paid to the government and utilizing tax shelters are generally not viewed as being unethical as long as they are legal. These tax shelters are usually created by the government to promote a certain desirable behavior, usually a long term investment.
Sometimes there is a fine line between a purchase being considered an investment or for personal use. In such a case, the intention of the individual, and cultural context, will determine whether Zakāh is due on something or not. For example, Mustafa buys a rare comic book for $50, even though the cover price of the comic was originally $2.50. He bought it because it is his favorite comic book story and has no intention to sell it, and it is common for people in his community to pay high prices for a good story, therefore Zakāh is not due on it. Eventually, he gifts this comic book to his friend Umar, who is not interested in the book itself but keeps it hoping to sell it one day because its value is increasing. Since Umar had the intention of investment, he must pay Zakāh on it.
Items are deemed to be for ‘personal use’ according to the intention of the owner. If someone purchases items mainly with the intention to escape paying Zakāh, they will be responsible in front of Allah on the Day of Judgment. For example, if Hasan wanted to evade paying Zakāh on the extra cash he owns he might think of buying diamonds and store them under the guise of ‘personal use’. However, in reality, his intention for buying them was to avoid paying Zakāh on his excess cash because he knows he could sell them at any time and convert them back into cash. Since his real intention is to sell them whenever he feels the need, they are considered investments or business assets and he must pay Zakāh on them. Maryam, on the other hand, buys some emeralds and rubies to use as decorations in her room. Since her intention to purchase them was for beautification and not as an investment, she will not pay Zakāh on them.
Should Access Restricted Accounts be Zakatable
Some investments have access restrictions. For example, Ahmad gave Talha $5,000 to invest as a partner in a home. Talha told him that he will not have access to the money he invested for three years, but after that he will get his money back plus the profit made from the sale of that house. Ahmad will have to pay Zakāh on this money, after adjusting for current profit or loss if that can be determined, every year. This is because he voluntarily gave up his ability to access that money with the hope of earning more profit than a liquid investment would yield. If Ahmad does not have enough liquid assets to pay Zakāh on the restricted investment, he may defer the payment until he has the money available and will not incur any sin for that. The reason for that is because the original principle when paying Zakāh is that it is taken from the actual wealth itself, but in this case it is restricted and not available.
Other investments like retirement plans have access restrictions and early withdrawal penalties in exchange for tax benefits. In the United States, a retirement plan such as a 401(k) or IRA (Individual Retirement Account) serve as containers to allow investments to grow on a tax-deferred basis. The caveat is that there are restrictions and penalties for early withdrawal of funds in addition to the fact that taxes will be incurred when the money is eventually withdrawn. These added variables complicate Zakāh calculations and has resulted in different rulings by scholars due to their varied understanding of how these financial instruments function and relate to the system of Zakāh:
- The first view is that Zakāh is due on the entire market value of the account every year. This is the opinion of Dr Muzammil Siddiqi, Shaykh Abdur Rahman Mangera, and the opinion I lean towards. The reasoning is that the person voluntarily put their money into this account. Since the account is owned by the individual the actual amount of capital in the account is given consideration since the investment grows through that full amount. Future taxes or possible penalties are not given consideration since they are not incurred at present and it is unknown if, when, and how much penalties and taxes will be deducted. Most retirement accounts provide incidental access to the invested wealth in cases of emergencies and for other reasons, which implies full ownership and control. For example, Maryam has $250,000 in a 401(k) in which she owns iShares Gold Trust ETF. This is a fund where investors pool their money together and buy physical gold which is kept in vaults scattered around the planet. Maryam will have to pay 2.5% of the value of this investment every year.
- The second view is that the early withdrawal penalty may be deducted from the value of the account when calculating Zakāh, in addition to deducting the current tax bracket of the individual, since this would be the true amount of unrestricted wealth the person would have if they were to withdraw the funds and incur all penalties on that day. This deduction may amount to about 20-50% of the market value of the account. This is the opinion of Shaykh Salah As-Sawy. The problem with this view is that it takes an incidental circumstance into consideration. Most people never access their retirement accounts early and therefore never incur any penalties, while their wealth continues to grow based on the full market value of the account, which represents their true net worth. For example, Mustafa has $100,000 in a 401(k) brokerage account. He has another $100,000 invested in Microsoft shares which is not in a 401(k). According to this opinion, he would owe $2500 in Zakah on the Microsoft shares [2.5% of $100,000] but would owe only $1500 on his shares of Apple [assuming the early withdrawal penalty was 10% and his tax bracket was 30%]. If Mustafa paid his Zakah from the extra money he had in his checking account, he would have received a massive Zakah deduction, even though this penalty was never actually incurred. Furthermore, if his shares of Apple increased by 10% the following year, that increase would be on the $100,000 and he would thus have $110,000 in Apple shares. Therefore, it does not seem to make sense to deduct a hypothetical cost which is not actually incurred.
- The third view is that Zakah is not due on a retirement account. Three arguments have been presented in defense of such a view:
- Zakah is only due on wealth that is fully accessible to the owner, so retirement accounts are exempt. This argument does not take into consideration two important facts concerning retirement accounts. First, that the person consciously placed their money into this account knowing that it would contain some access restrictions. This was done for the benefit that would accrue from such an account, either through tax breaks or employer matching. Second, it is incorrect to say that a person with a retirement account does not have access to it. For example, if Yusuf had $250,000 in his 401(k) retirement account and had no other wealth, then lost his job and could not pay rent for his house or cover his other bills, he would not become homeless and poor. He would have access to this account and would be able to withdraw the money and continue to live a comfortable lifestyle, thus classifying him as ‘wealthy’ from a Zakah perspective.
- Zakah is only due on wealth that is actively managed by its owner, so retirement accounts are exempt. This argument does not consider the fact that the investor was able to choose what type of investments to initially invest in. This could have been mutual funds, ETFs, bonds, or another investment type. Furthermore, the argument fails to consider that there is a money manager who is actively managing the account of the investor, and this was done by choice. When Muslim scholars exempted Zakah from a person who does not have ‘management access’ to their wealth, their concern was that this wealth would fail to be productive due to lack of decision making. However, this is not the case of retirement accounts. It is analogous to the situation where Amr signs a contract with Zayd for five years that his $100,000 will be managed by Zayd and he will make all financial decisions with regard to that wealth. The wealth is being managed, but by someone more qualified, which is why Amr passed investment decision authority over to Zayd in the first place.
- Zakah is not due on wealth that can only be accessed with a penalty. This argument does not seem to have any historical basis that I can locate. The reality is that the investor voluntarily signed up to be subject to penalties due to a tax benefit they would receive for having such an account. An analogous situation would be where Ali puts $10,000 every year into a special security guarded underground vault. The company that owns the vault charges a percentage of the wealth every time the wealth is either inserted or withdrawn due to their physical costs of accessing the underground vault. Ali cannot claim that his cash in the vault should be Zakah exempt merely because he cannot access that wealth without a penalty.
It is also important to keep in mind that when a company matches retirement contributions for an employee, Zakāh is only due once they become ‘vested’, which means that a span of time has passed over them such that their ownership is guaranteed and not revocable. If a person does not have enough liquid assets to pay the Zakāh because they have nothing to sell or give away, it may be deferred without sin. For example, Ali invests $7,000 every year into his retirement account which has now grown to $200,000. He must pay $5,000 in Zakāh [which is 2.5% of the $200,000] but he does not have any liquid assets in his account and is not able to withdraw from his retirement account. He may pay his Zakāh late but should consider investing less money for retirement in the future so that he may pay his Zakāh on time.