401(k) Purification Guide: How to Remove Impermissible Income | Musaffa Academy

Note: This article is for informational and educational purposes only. It does not constitute financial, tax, or legal advice. Consult a qualified financial advisor and a knowledgeable Islamic scholar for guidance specific to your situation.

For the millions of Muslim workers in the US, their primary retirement savings vehicle is the 401(k), often the only retirement plan offered by their employer, with a match to boot. But few will note that the typical 401(k) plan will have offerings that include companies that fail the Muslim worker’s own Shariah screening – companies that deal in usury (conventional banks), in alcoholic beverages, or earn riba (interest) income. Moreover, even with a plan that has Shariah-screened funds, there are still potential small amounts of impermissible income being earned on the fund level.

A significant and meaningful question faced by Muslim employees who wish to participate in a 401(k) plan and benefit from an employer matching fund and earn interest on those contributions to save for retirement; while at the same time, not incurring any impermissible earnings that have not been purified. The question also pertains to withdrawing those monies prior to retirement age without incurring an early withdrawal penalty.

How Does 401(k) Purification Work? This Guide Explains Everything. Here’s a brief overview of the 401(k) purification rule, what’s considered impermissible income, how to calculate the impure amount, and how Traditional versus Roth 401(k) structures differ when it comes to retirement accounts containing impermissible income.

First: What Is Purification, and Why Does It Apply to a 401(k)?

Purification (tathīr) of wealth is different from zakat. Zakat is a compulsory payment on your total eligible wealth at a rate of 2.5% annually, there is reward for zakat but there is no reward for tathīr. Tathīr means to remove the impermissible from your wealth. It does not mean to give what is obligatory (fard). In fact, one of the reasons for tathīr is to help Muslims who are in need of and looking for halal sources of income. Tathīr means to purify your wealth by giving away a portion of your income to charity.

Within the 401(k) arena, the process of purification is necessary since the “best” mutual fund choice (including Index Funds, Shariah screened funds and actively managed funds) contains companies that generate impermissible income such as interest on cash deposits, a very small percentage of revenue from impermissible businesses and products, or dividend earnings on shares of companies engaged in impermissible activities. Broad market index funds actually comprise a larger percentage of impermissible income than other available mutual fund options. Shariah screened mutual fund options will consist of a much smaller percentage of residual impermissible income.

Although the income may have been contributed to a retirement account or is delayed until distributions from the account, you are still considered the beneficial owner of the income or accumulation and cannot include an impermissible amount.

Can You Participate in a 401(k) at All?

But before we get bogged down on that prior question, we have to challenge a fundamental premise apparently held by many scholars, which is that Muslim employees can participate in an employer-sponsored 410(k) or similar plan, even where the contribution is toward a matching gift by the employer.

One might argue that the employer match is part of one’s salary and that, by accepting 401(k) plans, one is throwing away the salary that God has ordained. However, there is very considerable consensus that the employer match is not riba and is permissible.

Can you invest 100% of your 401(k) plan assets in Shariah compliant investments? These resources were developed to address a market deficit and thrive in it. While Islamic law is binding, it has room for the principle of necessity (ḍarura) and holds individuals accountable for what they can do under the circumstances. That is, once the best available investment options have been selected from a plan’s mutual fund options, the investor is accountable for the remaining impermissible proceeds, but not for what he or she could not do under the circumstances.

While there is limited Islamic finance scholarship on the topic, there is consensus that one can participate in a 401(k) with the correct intention, good faith in selecting a fund, and the continuous act of purification.

Step 1: Choose the Most Shariah-Compliant Funds Available

Remove the worst options from your choices, then determine how pure a solution you need.

Most 401(k) plans come with a plethora of investment options for participants to choose from, typically ranging from 10 to 30 options. This is often organized in a ranking of preference from highest to lowest by the employee. With the growing popularity of dedicated Shariah and ESG options that do not invest in conventional financials, alcohol, tobacco and weapons, it is becoming increasingly important for employees to understand what options are available and how they differ from more traditional investment options. In addition to these options, many 401(k) plans also offer broad index equity funds that have a low weight of financial sector stocks, growth equity funds or technology funds with a low weight of banks and insurance companies. While target date retirement funds would be the least preferred option of this list due to their high bond weight and resulting low interest income, understanding the differences can empower employees to maximize their retirement savings.

One should try to avoid Bond Funds and Money Market Funds as much as possible in their 401(k). They look to earn a lot of interest and in many cases can have a significant impact on one’s retirement savings but the returns are largely hollow. The purification would be quite substantial and the holding is not particularly halal. Most 401(k) plans have a self-directed brokerage window where one can purchase and hold mutual funds and ETFs not currently available in the 401(k) plan menu. There are many Shariah-screened mutual funds and ETFs that one can include in their 401(k).

Step 2: Calculate the Impermissible Income to Purify

So far so good. But what is the “excessive” amount of “annual investment income” to which the thresholds refer? Two different methods for determining that amount are outlined. However, in limited circumstances where specific fund information is unavailable or inaccessible, a third method may be utilized. Presumably, however, such circumstances are unlikely, if they exist at all.

Method A: Using a Published Purification Ratio

Most Shariah-screened funds and Islamic investment platforms do provide a form of annual purification ratio i.e the percentage of the impermissible income. Most importantly, some of them do provide the figure as a percentage of the Total Distributions or Net Asset Value of the fund. So please multiply this ratio with your account value in the respective fund/s or the total distributions received.

Following the recent publication of the new purification ratio by the Shariah-screened fund we invest in, I updated the numbers above. impermissible income to purify: 1.2% of $24,000 = $288. So, it is time to donate $288 to charity.

Use the Musaffa Purification calculator here.

Method B: Screening the Fund’s Holdings Yourself

Since the publication ratio is not available, an estimate for the impermissible income has to be made. Most fund providers publish the quarterly holdings, either on their websites or in their annual reports. Islamic finance screening services also exist to help identify the impermissible components of each holding. An estimate based on the available time and resources can therefore be reasonable.

Method C: Conservative Flat Rate (Practical Shortcut)

When a specific fund or investment is not available, scholars and practitioners of Islamic finance resort to fixed conservative percentages of the annual fund value for purification. For broad market index funds, a typical range used for this calculation is 2% to 5%, while for Shariah-screened equity funds the percentage used would be lower at 0.5% to 1.5%. Even when exact data is not available, a Muslim investor can use a reasonable estimate for the purpose. The scholar opines that a reasonable estimate can be sought from and a higher estimate used if any doubt arises.

Step 3: How to Donate Without Withdrawing from the 401(k)

In the recent “Purification Challenge” on not “withdrawing the withdrawals”, an important point seems to have been left out. How are people going to withdraw the impermissible amount from their 401(k)? Sure, that will still trigger a taxable event (unless you have set up an IRA to contribute to previously in a taxable account), and a 10% early withdrawal penalty (unless you are 59 1/2 years old or older). The answer is no.

A very important point. The Purification does NOT require the donation to come from the same pool of money where the impermissible income exists. Thus, if a person has $500 of impermissible income in his $500,000 401k, he does not have to remove the impermissible income from the 401k itself and thus put himself in an enormous loss. Rather, he simply donates that amount of money from his bank account or from his take-home pay to a proper charity. The 401k does not even have to know.

Although many posuke and poskim still apply unique standards with respect to 401(k) plans, the majority of poskei hadaf consider the tshuvos with respect to “purifying” such an account to be relatively straightforward. Basically any income which went to the account in a prohibited manner is offset by a donation to tzedaka for the amount of the prohibited income, and is not affected by the amount of money in the particular 401(k) account which generated the prohibited income.

Donating to righteous goals by donating to sadaqah-eligible recipients, Islamic charities and general humanitarian causes that will help to achieve the goal of purification, should however not be counted as part of the Zakat donation as the criteria for the recipients and calculations do not allow for this.

Traditional 401(k) vs Roth 401(k): Does the Structure Matter for Purification?

In prior articles, we explored whether contributions to a traditional 401(k) or Roth 401(k) impact one’s ability to keep or pass on his or her assets. Here, we’ll delve deeper into the consequences of each plan type from a purification standpoint.

If you contribute to an IRA, whether it is a Roth IRA or a Traditional IRA is usually a tax decision. But it can affect your "purification" number, so you should know who contributed to an IRA and how much they contributed.

Traditional 401(k)

Before it is contributed to the plan, a Traditional 401(k) contribution is tax-deductible to the contributor. All of the account balance – the employer match, the growth of the investment, and the contributions to the account – is taxable to you when you withdraw the amount from the plan. The gross balance of the Traditional 401(k) plan is the asset to calculate the amount of assets that you need to purify from. Traditional 401(k) plans are commonly known as pre-tax plans, meaning you are the beneficial owner of the money in the account before retirement. Although there is some limited discussion regarding whether to calculate and pay purification on the pre-tax amount of money in the account or the post-tax amount of money distributed from the account, the more conservative and accepted practice is to calculate and pay for purification on the higher value of the two – the pre-tax amount of money in the account. This is the amount that is truly yours, and the required tax payment when you withdraw the account balance does not change the amount that needs to be purified.

Roth 401(k)

Contributions to a contribution are prefunded but come out of after-tax contributions and are qualified distributions in retirement tax-free. So for balance purposes your Roth 401(k) balance is after-tax money the whole time so you don’t get any pre-tax gross-up for it in your purification calculations. But you still have to purify the impermissible income, you do that by making donations of charity from your available resources with the same level of obligation as if you were in a Traditional IRA.

Which Is Better for a Muslim Investor?

From a Shariah perspective, the Traditional Structure and the Roth Structure are neutral. Neither Structure is better or worse from a Shariah Perspective. Both Structures allow for the same investment options (fund menus) and the same impure income that requires purification. From a tax perspective, the decision between the Traditional and Roth Structures is a function of your current vs. future tax rate, income and retirement horizon. It is a question best answered by a financial advisor.

Also, since the employer may offer a Roth 401(k) option, if the plan does offer Shariah screened mutual funds, the contributor may wish to put contributions into the Roth 401(k) option, as future tax-free growth would be based upon a fully purified after-tax contribution basis. This is a general planning consideration and not a requirement of Shariah.

401(k) Purification: At a Glance

Building a Disciplined Annual Practice

In calculating the 401(k) purification it should be an annual event to keep it straight forward and coincide with the zakat anniversary where we calculate and pay zakat. Perhaps we could add about 30 minutes to the process to determine the impermissible amount and then using the accessible wealth, pay for it also. This would be a supplement to our current process of calculating and paying the amount of zakat and other obligations due on the total amount of wealth that is zakatable annually.

So how good does a Muslim have to be? Not perfect, for our legal systems are not founded upon Shariah principles but rather upon secular legal systems that do not demand compliance with Shariah laws. What Allah demands of us is good faith on our part, the best possible options, honest calculation, on time payment, financial accountability etc. These are the parameters of dealing with wealth in the Islamic worldview. Selecting a 401(k) and contributing to it with the intent of pleasing Allah, and choosing the best Shariah compliant fund available in the market is something that a Muslim can do. Allah does not place upon a soul a burden it is incapable of bearing.

And Allah knows best.

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