A note to the reader: In my last piece, I shared the importance of a 401(k) retirement account and explored the different ways you can set it up in a halal way. Below, we’re going to focus on some practical ways you can cleanse any impermissible earnings in your 401(k) by way of purification.
Purification, in all its forms, is a key part of our faith. It renews our intentions and puts us on a course of gaining a deeper understanding of our actions. In this piece, I'll discuss and reflect on the importance of purifying your investments and some options on how you can do this today—with real-life examples.
What is purification and how does it work?
In this context, “purification” refers to giving away, or donating, the haram (impermissible) portions of your wealth. The money you give away through purification doesn’t count as sadaqah according to most scholars because the purpose is to cleanse your wealth (Al-Azhari, 2021). This is a similar concept to when Muslims purify their savings accounts of interest earnings. Purification is very important because your investments today will be the source of your income in the future, and it’s critical to have halal sources of income in your life.
When it comes to investments, what you need to purify are the profits/earnings from those investments, not the principal. For example, if you invest $100 in a stock of a company that has a small portion of haram revenue, and that $100 becomes $500, you’ll need to purify the $400 in gains by donating the haram portion of it.
Purification of retirement accounts like a 401(k) can be tricky because of the taxes and penalties you would have to pay for an early withdrawal. This is a common scenario that many Muslim professionals find themselves having to deal with.
How to purify your 401(k) of haram earnings
Before we dive in, keep in mind there is no one-size-fits-all solution; you need to do what’s best for your personal situation. None of the suggestions I share below are ideal so they should only be treated as temporary workarounds. Ideally, you should advocate for halal investment options so that purification isn't something you have to worry about.
That being said, let's explore some of your options.
1. Do an early withdrawal
Withdraw the haram portion of the gains from your 401(k) and donate them once a year. Keep in mind that the IRS will automatically tax the amount you withdraw at 20% and there is also a 10% penalty on top of that.
2. Use your cash savings
Donate the haram portion of your gains out of your regular savings accounts.
- With this option, you don’t touch your 401(k) account at all.
- This might be easier to do when you don’t have as much invested in your 401(k) and might be more difficult as your earnings compound.
- To go with this option, approximate how much you'll be contributing to your 401(k) during the year and how much you will potentially be earning on those contributions, and set aside that amount every month. Figure out how much of your investment is haram and assume 10% growth, which is the average stock market return.
3. Rollover your 401(k) to a Traditional IRA
Keep note of how much of your gains you need to purify each year from your 401(k) and then purify the total amount after you leave that job by doing a traditional IRA rollover.
- When you leave your current position, you can do a 401(k) to traditional IRA rollover.
- Withdraw the total amount you need to purify and donate it. Your withdrawal will be counted as income and you will be taxed at your normal tax bracket + a 10% tax penalty.
Note: There is something called the IRA Charitable contributions option, which allows you to donate up to $100,000 from your IRA directly to a charity without being taxed. However, this option is only available to you if you are over 70.5 years old. Before that, any withdrawals from your IRA will be taxed.
4. Convert your 401(k) into a Roth IRA
Keep note of how much of your gains you need to purify each year from your 401(k) and then purify the total amount after you leave that job by doing a Roth IRA conversion.
Consult a CPA before attempting this option.
- Rollover your 401(k)/403(b) to a traditional IRA and then do a Roth IRA conversion if you want tax-free growth. It is best to do a broker-to-broker transfer here which means your 401(k) broker rolls your money over to the broker housing your IRA directly. The other option is that your 401(k) provider liquidates the money, sends it to you, and then you have to manually put that money in your Roth. The only problem with this option is that you get hit with taxes and fees if you don’t manually put the money in the IRA within 60 days.
- When you transfer from a traditional IRA to a Roth IRA, the money just sits there as cash in a money market account, so remember to manually re-invest the money (i.e., buy the new investments).
- Any time you do a Roth conversion, you will have to wait 5 years in order to do penalty-free withdrawals of your own contributions.
- When you go to re-invest the funds in your Roth IRA, only invest the part that is halal. Keep the haram portion as cash so it doesn’t grow, and then after the 5-year waiting period is up, withdraw that money and donate it.
Keep in mind that any time you do a traditional IRA (pre-tax) to Roth IRA transfer, you will have to pay taxes on the entire amount you transfer over. As such, this option might be best if you don’t have too much in your retirement accounts that will be taxed.
Let’s look at a practical example of how to use the 401(k) to Roth IRA conversion option.
- Total amount in 401(k) after you leave your job: $50,000
- Portion of the fund that is haram: 30%
- Your contributions: $30,000
- Your gains: $20,000
- Purification amount: $6,000 (30% of $20,000)
Start by rolling over your 401(k)/403(b) to a traditional IRA and then do a Roth IRA conversion if you want tax-free growth. Then, only invest from the portion that is halal:
- Keep $6,000 in cash (the part that you need to purify) a then donate it after 5 years are up.
- Re-invest the $44,000 into halal options within your Roth IRA right away.
Note: With this scenario, if you roll over the entire $50,000 to your Roth IRA, it will count as taxable income and you will have to pay taxes on the full amount.
I want to reiterate the importance of purifying your 401(k) from haram income. Your 401(k) contributions will be your source of income in the future during retirement, and it's imperative that your income is halal to receive Allah's blessings. However, as shown in this article, due to the restrictions the IRS puts on 401(k) withdrawals, all of the purification options will likely result in large tax bills and/or penalties. As such, it would be in your best interest to figure out whether you can move your funds into halal investments going forward.
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