Zakat On Retirement Accounts

When we’re saving for retirement, there are generally three types of accounts we can use to save:

1. Regular Brokerage Accounts: A regular brokerage account, often known as a taxable account, allows you to buy and sell securities like stocks, bonds, and mutual funds. Think of your Schwab, Ameritrade, or fidelity account you can buy stocks through. Any capital gains, dividends, or interest earned in these accounts are subject to taxes in the year they are realized.

For example: If you purchase shares in a company through a regular brokerage account and sell them at a higher price, the profit you make will be taxed in that tax year that you sell them.

2. Tax-Advantaged Accounts: A tax-advantaged account refers to any type of investment account that offers tax benefits, such as tax deductions on contributions, tax-free growth, or tax-free withdrawals.

For example: Contributions to a Roth IRA are made with money you’ve always paid taxes on (after-tax dollars). The earnings and withdrawals are tax-free, under certain conditions. This means you don't get a tax deduction for contributions, but you benefit from tax-free growth and can withdraw your money tax-free in retirement, making it a powerful tax-advantaged saving tool.

3. Tax-Deferred Accounts: Tax-deferred accounts are investment accounts where taxes on capital gains, dividends, and interest income are deferred until the investor takes withdrawals. These accounts are often used for retirement savings, such as 401(k)s and IRAs (Individual Retirement Accounts).

For example: When you contribute to a 401(k) plan, the money you contribute is paid into the account *before* you pay taxes on it. This means that the income you take home is lower, reducing your tax burden for that year. The investments grow tax-deferred, and you only pay taxes on the money when you withdraw it during retirement, potentially at a lower tax rate.

Each of these account types has its own set of rules, benefits, and considerations, making them suitable for different investment strategies and financial goals.

HOW DO WE PAY ZAKAT ON THESE ACCOUNTS

But the question remains, how do we pay Zakat on these accounts? In each of these accounts, you have a certain amount of control.

For a brokerage account, you have full control.

You put in money, pull out money, and pay taxes whenever you do. You can access the funds in this account just like you can your bank account. The only difference is: you have made the intention that this stocks and funds in this account are going to sit there for a long and growth passively until you retire.

For a Roth IRA, you can put in money, but then the money in your account is looked at differently.

If you want to pull out contributions (the money you put in to be invested) you can do that because you’ve already paid taxes on them. There is no penalty for doing so. For the gains, means the money made on top of your contributions because of what you invested in, then you *can’t* pull them out unless you pay a penalty or reach retirement. The contributions are just like the funds in your brokerage account above, but the gains can’t be touched until retirement.

For the 401k, you can put in money, but you cannot pull out contributions or gains

unless you pay taxes and penalties now, then take out cash OR you reach retirement age. So you have no control over spending from these funds freely, even though you own them.

YOU STILL HAVEN’T ANSWERED THE QUESTION

I know. I’m getting there 😉. Before we talk about how to deal with the Zakat on each of these accounts, let’s discuss a few principles that are important to understanding them first.

Principle #1: You only pay Zakat on what you freely control.

Principle #2: You only pay Zakat on realized gains.

Principle #3: You only pay Zakat on current, liquid assets.

Principle #1: You only pay Zakat on what you freely control.

This principle underlines the importance of ownership and control over assets as a prerequisite for Zakat liability. In essence, it dictates that Zakat is only due on wealth or assets over which an individual has full ownership and the free ability to dispose of. This excludes wealth that is not fully owned or accessible for personal use. As al-Buhooti states in al-Kashshāf (2/170), “Among the conditions of Zakat is complete ownership, as stated in Al-Furū‘. This is because partial ownership is not a complete blessing, and Zakat is only obligatory in exchange for it. Complete ownership means what is in his possession has not been claimed by others; he can dispose of it as he chooses, and its benefits accrue to him.”

For instance, if you have money in a trust that you cannot access until a certain age or condition is met, that wealth is not subject to Zakat until it becomes fully accessible to you. The rationale behind this principle is grounded in the broader Islamic legal maxim that responsibility is tied to capability and authority over one's wealth.

Principle #2: You only pay Zakat on realized gains.

Zakat is concerned with the wealth that has been actualized and is tangible in nature. This principle emphasizes that only the gains which have been realized over the Zakat year are considered for Zakat calculation. Unrealized gains, such as investments that have increased in value but have not been sold, are not subject to Zakat.

This principle is found in the statements of the companions and the Tābi‘īn, and is reiterated throughout the works of Fiqh and Ḥadīth, that there is “Zakat is only on realized wealth.” For instance, see the chapter with the same title in Muṣannaf ‘AbdulRazzāq (4/100) and similar in al-Mughni (4/259).

For example, if you invest in pre-revenue startup that may have appreciated in value, but you haven't sold and there is no firm valuation, then this unrealized increase is not counted for Zakat purposes until it is realized by IPO or liquidation. This principle ensures that Zakat obligations are based on actual, rather than potential, financial growth, aligning with the Islamic legal principle of certainty over uncertainty.

Principle #3: You only pay Zakat on current, liquid assets.

The principle of paying Zakat focuses on consistency across different types of assets by emphasizing the distinction between fixed assets and current, liquid assets. For instance:

- If you own a home and have a safe with cash, Zakat is payable on the cash within the safe, not the home's market value.

- Owning an apartment building means paying Zakat on the cash in your safe and the income generated from rentals, but not on the building's valuation itself.

- For a factory owner, Zakat obligations cover the cash on hand, receivables, and the inventory being sold. However, the value of the physical factory building, forklifts, and other fixed assets are exempt.

- If you had lost wealth, or wealth that was embargoed or frozen, you would not pay Zakat on it at all, because it is not liquid and is inaccessible to you.

This approach underscores liquidity and access, where Zakat is due only on assets that are liquid or can be easily accessed and converted into cash. It includes cash, bank balances, stocks, and business merchandise. Non-liquid assets, such as real estate not intended for sale, personal vehicles, and household furniture, are generally not subject to Zakat. By extension, wealth that is inaccessible like frozen accounts, lost wealth, and debts that cannot be paid – although they are technically ‘owned’ by you – are not included, because they are not liquid and current.

By focusing on the liquidity and access aspect of assets for Zakat calculation, this principle ensures that fulfilling Zakat obligations does not lead to financial distress by requiring individuals to sell off non-liquid assets, many times at a steep discount or for pennies on the dollar, just to fulfill this obligation of Zakat. This embodies the Islamic values of ease and preventing hardship in religious practice.

NOW TO ANSWER THE QUESTION

1. Regular Brokerage Accounts like your trading account:

- If you are a day trader or swing trader,

Then you should assess the market value of their portfolio, treating it as equivalent to cash, and pay Zakat accordingly. This is because the entire account is liquid and accessible to you, and therefore you take the entire account value and multiply it by 2.5%.

Example: Your account has 12k value, multiply that by 2.5% = $300 is your Zakat.

- If you are in a long term buy-and-hold position,

And you can access your accounts without penalty, then apply this specific formula: multiply the market value by 0.075%. This formula, effectively (Market Value * 30%) * 2.5%, targets current assets, similar to how one would only pay Zakat on the rental income from a building rather than its full value.

Example: Your account has 25k value, so (25k*30%)*2.5% = 25k*0.0075 = $187.50 is your Zakat.

2. Tax-Advantaged Accounts like your Roth IRA:

The same formula above for long term buy and hold applies here as well, because you can access your contributions. However, in this situation you will not pay on the market value. Instead, you will use the total contributions.

For example, your Roth IRA has 52k in it, and you’ve been contributing to it for 8 years, putting in 6k a year. So 6k times 8 equals 48k.

Therefore, (48k*30%)*2.5% = 48k*0.0075 = $360.00 is your Zakat.

3. Tax-Deferred Accounts like your 401k or Traditional IRA:

Before retirement:

- If you take cash out before you retire (a distribution) then pay 2.5% on the amount you take out.

- If you never take money out of these accounts before retirement, you will not have to pay Zakat on them. They are like the lost and frozen funds we mentioned above. Once you gain access to them, then you will pay Zakat on them as mentioned below.

After Retirement:

    - You decide to cash out:

If when you retire, you decide to cash out your 401k account completely, you are required to pay 2.5% once on the entire amount. Why would you cash out completely? Maybe you want to buy property, maybe start a business, there are a lot of possibilities. But because you haven’t paid Zakat on this account for this entire time, you consider all the years that passed like one time period. You pay on the total amount once when you receive it, then every year on anything left after that.

    - You decide to stay invested:

However, if you choose to stay invested, whether in the same account or through a rollover, your investment is considered a long-term passive investment. For Zakat calculation on such investments, you should use the formula: Market Value * 0.0075, which is equivalent to (Market Value * 30%) * 2.5%. This calculation should be performed once you gain access to your investment and then annually thereafter to fulfill your Zakat obligations accurately.

IN CONCLUSION

The principles of paying Zakat on retirement accounts are underscored by a commitment to consistency across various asset types, distinguishing between fixed assets and current, liquid assets as well as access and expected benefit from those assets. This distinction is crucial, especially when considering shares held within retirement accounts, effectively making the account holder a long-term investor in various businesses. The application of the 30% rule serves as a practical shorthand, approximating the portion of a company's assets that are current—such as cash, receivables, and inventory—as opposed to fixed assets like buildings and equipment.

Taking into consideration the differences between what is and is not accessible without penalty, we ensure that fulfilling Zakat obligations does not lead to financial distress by requiring individuals to sell off non-liquid assets many times at a steep discount or for pennies on the dollar, just to fulfill this obligation of Zakat, or to use liquid assets outside of those investments (like salary) to pay an amount that may be larger than what current income allows. This embodies the Islamic values of ease and preventing hardship in religious practice.

While this quick article does not encapsulate all of the reasons and rationale behind this ruling, as my intention here is not to write a legal opinion on the topic, I am confident that the opinion I’ve expressed here is well substantiated and this article provides you with a window into that thought process. The approach I’ve outlined here ensures that Zakat calculations reflect the true, accessible value of one's investments, aligning with Islamic teachings on ownership, control, and the nature of wealth subject to Zakat. By applying these principles thoughtfully, investors can fulfill their religious obligations without undue hardship, maintaining the spirit of ease and fairness that Zakat embodies.