Professor Shafiqur Rahman

Transcription

1 Zakat on Retirement Plans Shafiqur Rahman Professor of Banking and Finance School of Business Administration Portland State University Abstract This paper compares and contrasts alternative pension plans in the market place and their status as zakatable wealth or property. These plans differ in terms of who is responsible for providing funds for pension benefit to the retirees upon retirement and who is responsible for bearing investment risk. Whether a pension plan is subject to zakat immediately or upon receipt at retirement depends on immediate accessibility to and ownership of the funds in the account. It makes no difference whether employer and/or the employee is (are) responsible for funding the plan and who bears the investment risk. There is consensus among Muslim jurists and shariah scholars that mandatory plans offered as a part of compensation and benefit package for a job are subject to zakat when money is received upon retirement and non-mandatory plans offered as replacement for or supplement to employer-sponsored plans with voluntary employee participation are subject to zakat in each year of employment after taking into consideration taxes and penalty for early withdrawal. Keywords: Pension, defined-benefit, defined-contribution, Social Security, and zakat. May 24 th, 2014 Correspondence Address: Professor Shafiqur Rahman School of Business Administration Portland State University P. O. Box 751 Portland, OR , USA (Voice) (Fax) [email protected]

2 Zakat on Retirement Plans Shafiqur Rahman I. Introduction Zakat, one of the five pillars of Islam, means purification and growth. It is an obligation on every Muslim possessing a minimum threshold of wealth (nisab) for a complete cycle of one Islamic lunar year (hawl). There is consensus among Islamic jurists that zakat must be paid on crops, fruit, livestock, merchandise, minerals, gold, silver, and treasures (Sabiq, 1991). Monetary assets such as currency and assets that can be converted into currency are also subject to zakat as currency has replaced gold and silver as a medium of exchange and store of value. This paper examines whether zakat is due on a special type of monetary asset: pension and retirement accounts. In the US alone, billions of dollars of monetary assets are held in the form of pension assets for Muslim Americans. Many of these Muslim Americans face a serious challenge of determining which alternative form of pension accounts are subject to zakat. There is no prior research work in the extant literature examining zakatability of alternative retirement plans offered in the US marketplace. This paper fills this void and provides a comprehensive survey and analysis of all available retirement plans and their treatment with respect to zakat. This paper is organized as follows: Section II discusses various types of retirement accounts and compares and contrasts alternative forms of retirement accounts based on contributions, investment risks, ownership control, and benefits. Section III discusses which of these plans are subject to zakat and the timing of payment of zakat. Section IV concludes the paper. II. Pension Plans A pension or retirement plan is a safety net or nest egg that provides a person with financial resources (i.e., cash flow in the form of monthly payments or a lump sum amount) to pay for all expenses when he or she leaves active the workforce and has no income or paycheck. These plans are sponsored by employers (for example, private and public institutions such as for-profit and not-for-profit corporations or state, city, and local governmental units, etc.,) or the federal government, or they are offered by investment brokerage firms as self-directed plans driven by tax incentives. These plans 1

3 are funded by periodic (monthly, quarterly, annual, or one-time) contributions from plan sponsors or employers and/or the beneficiary employee during his or her active working life. There is explosion of a wide variety of pension plans in the marketplace differing in forms and substances as well as contributions and benefits. However, all of these plans can be divided into two primary categories based on whether the employer or plan sponsor is responsible for guaranteeing the stream of cash flows to the retiree based on some pre-determined formula or the retiree is responsible for making prudent investment decisions with the help of professional fund managers to generate stream of cash flows for retirement life. The other key differences between the two are in the terms of control (i.e., whether the sponsor or beneficiary is responsible for investment risk and portfolio management associated with funds invested to generate future stream of cash flows upon retirement) and portability (i.e., the ability to take your retirement plan with you to a new job). These two categories of pension plan are known as defined-benefit plan and defined-contribution plan. Any existing plan can be put into one or other category based on the structure, design, and objective of the plan. IIA. Defined-Benefit Plan In a defined-benefit pension plan, the employer or plan sponsor makes a commitment to provide a certain amount of cash flow (either periodically or as a lump sum amount) to the employee upon retirement. The payments to the retiree are defined, i.e., determined by a statutory formula based on such factors as length of service with the employer, age at the time of retirement, salary history, highest salary, and salary before retirement. For example, the Teacher Retirement System (TRS) of Texas, a pension plan for all public higher education and public K-12 education employees in the state of Texas, calculates monthly pension payment as the number of years of service multiplied by 2.3 percent of the average of the highest five annual salaries and then divided by 12 (Texas Higher Education Coordinating Board, 2013). In a defined-benefit plan, the employer is responsible for coming up with the money to pay your benefit. The cash flows required to make benefit payments to the retiree are partially generated by reinvesting periodic contributions from employer and/or employee during the period the employee works for the employer if the employer sets aside money for this purpose. Such defined-benefit plans are known as funded defined-benefit plans. If no funds are set aside by the employer to pay for benefits upon 2

4 retirement and employer pays the benefits as and when the employee retires, it is known as unfunded defined-benefit plan. In a defined-benefit plan, investment risks are absorbed by the employer. If the contributions to a funded plan do not generate terminal cash flows sufficient to cover the promised stream of cash flows at retirement, the employer is responsible to make up for the difference. This may result in a drag on employer s earnings or revenues in the event there is a shortfall. On the other hand, defined-benefit plan is advantageous to employees participating in the plan because they are guaranteed a certain amount of stable pension income during retirement life without requiring them to make any investment decisions. McWhinney (2009) has pointed out that, from an employer s perspective, definedbenefit plans are an ongoing liability. Funding for the plans must come from corporate earnings, and this has a direct impact on profits. He cites examples of companies announcing a freeze on their defined-benefit plans, which means the companies stopped funding the plan. A freeze is the first step toward the elimination of the plan. IBM froze its defined-benefit pension plan in 2006, followed by Verizon, Lockheed Martin, and Motorola. Furthermore, under current pension plan laws, pension plan sponsors are required to fully fund their defined-benefit pension plans. As a result, many employers are switching from defined-benefit plan to defined-contribution plan to reduce pressure on corporate earnings. This has led to gradual disappearance of defined-benefit plans. IIB. Defined-Contribution Plan In a defined-contribution plan, the employer contributes an amount equal to a certain percentage of the employee s current salary each period (monthly or quarterly). These funds, along with the periodic contribution by the employee (which is required in most plans), are invested in financial market and employees participating in the plan choose from a variety of investments alternatives offered by several investment firms approved by the employer. For example, Oregon University System (OUS) currently pays on a monthly basis (1) an amount equal to 16.5 percent of an OUS employee s salary as the employer contribution and (2) another 6.o percent as employee contribution (for a total of 22.5 percent) to an Optional Retirement Plan (ORP) for employees hired prior to August 29, 2003 (Oregon University System, 2014). Investment of these contributions are currently offered through these providers Fidelity Investments, Teachers Insurance and Annuity Association - College Retirement Equities Fund (TIAA-CREF), and Variable 3

5 Annuity Life Insurance Company (VALIC). Upon retirement, the employee will receive accumulated funds of both employer and employee contributions and income generated from reinvestment of those funds. In this plan, employer s contributions towards retirement account are defined and unlike a defined-benefit plan where employee s retirement benefits are pre-determined, the benefits are not defined. Employee s retirement incomes are uncertain and depend on contributions (by the employer and/or employee) to retirement account as well as the investment performance (income or loss) of the invested assets. Investment income will depend, to a large extent, on how much risk the employee is willing to tolerate. The employee absorbs investment risk and makes investment decisions. One big advantage of defined-contribution plan is that it is fully portable, i.e., employees can take it to another employer. IIC. Variation of Defined-Benefit Plan Social Security is a federal government benefit program initiated in While the program provides disability income, veterans pensions, public housing and even the food stamp program, it is most commonly associated with retirement benefits (McWinney, 2011). Employees pay Social Security taxes on earnings. To generate funds for paying Social Security benefits upon retirement, the employee pays 4.2 percent of his or her annual salary, up to a certain amount (that amount is $117,000 in 2014) and the employer pays 6.2 percent in Social Security taxes. Self-employed individuals pay the combined employee and employer share (10.4 percent) in Social Security taxes. These taxes are converted into a retirement benefit upon retirement using a standard formula that takes into account factors such as age at the time of retirement, the number of years Social Security taxes paid, and the amount of taxes paid. To qualify for benefits, when employees work and pay Social Security taxes, they earn credits towards Social Security benefits. In 2014, employees earn one credit for each $1,200 in earnings up to a maximum of four credits per year. When an employee has earned $4,800, he or she has earned his or her four credits for the year. The amount of money needed to earn one credit usually goes up every year. Most people need 40 credits (at least 10 years of work), earned over their working lifetime, to receive retirement benefits (Social Security Administration, 2014). 4

6 Retiring employees can begin to receive Social Security retirement benefits as early as age 62. However, employees will receive a reduced benefit they you retire before the full retirement age of 67. For example, if an employee retires at age 62, his or her benefit would be about 25 percent lower than what it would be if he or she waited until the full retirement age of 67. If an employee continues working until age 70, the benefit is even greater than if the employee stopped working at the full retirement age of 67. The Social Security benefit is designed as a defined-benefit plan and is funded through Social Security or payroll taxes. Unlike a defined-contribution plan, there will be no yearly balance in a future Social Security recipient s account reflecting possible future benefit payments. The money employees pay in taxes is not held in a personal account to use when they get benefits. Instead, these taxes are used immediately to pay people who are getting benefits currently. Any surplus money goes to the Social Security trust funds, rather than an account designated solely for the beneficiary. It is estimated that by 2037, the payroll taxes will be enough to pay only 78 percent of scheduled benefits. The estimated benefits are based on current law, and Congress has made changes to the law in the past and can do so any time. IID. Variations of Defined-Contribution Plan Variations of defined-contribution plans are self-directed retirement programs such as 401(k)s and IRAs. In these plans, retirement benefits are not pre-determined and are uncertain. These benefits are dependent on the performance of the investment portfolio and the retiree absorbs the investment risk. These plans offer certain tax advantages to the participants in exchange for restrictions and/or severe penalties for early withdrawal before reaching 59½ years of age. In some cases, employer matches employee s contribution up to a certain limit. A 401(k) is a supplementary retirement savings plan sponsored by an employer as a replacement for employer-sponsored pension plan. Investment management of the fund is provided by several brokerage houses selected by the employer. Many businesses find it more expensive to run and fund pension plan and offer 401(k)s to minimize costs. These arrangements allow employees to contribute and invest a part of their paycheck before taxes are taken out. Taxes are payable upon retirement when money is withdrawn from the account, and the beneficiary 5

7 then enters a post-retirement tax bracket that is lower than the pre-retirement tax bracket. An individual retirement account (IRA) is a saving plan for retirement that provides tax benefit for your contributions as well as income generated from these contributions. An account is usually set up at a financial institution like Fidelity Investments where individuals can contribute part of their paychecks or earnings to save for retirement without paying taxes on these contributions. If an individual doesn t have access to an employer-sponsored plan, he or she can contribute to an IRA as an alternative. There are three main types of IRAs Traditional, Roth, and Rollover. In a Traditional IRA, periodic contributions can be deducted on tax returns (i.e., a plan contribution is considered tax-free income currently) and those contributions and any income from reinvestment are taxable only upon retirement when withdrawn. Many retirees end up in a lower tax bracket upon retirement, so the contributions and income generated are subject to a substantially lower tax rate. In a Roth IRA, contributions are currently taxable. However, income generated from these contributions can grow tax-free and plan contributions and reinvestment incomes can be withdrawn tax-free upon retirement, provided that certain conditions are met. In a Rollover IRA, money from an employer-sponsored plan can be transferred and reinvested. IIE. Choosing Between Alternative Plans Exhibit 1 compares defined-benefit and defined-contribution plans. A participant s willingness and ability to take risks and responsibilities to make investment and portfolio decisions are the most important distinguishing factors when choosing between a defined-benefit and defined-contribution retirement plan. However, other factors like age, current and anticipated salary in the coming years, expected length of service with current employer, previous retirement program participation, current and anticipated financial position may make a difference. In terms of benefits in relation to employee contributions, defined-benefit plans generally favor the long-term employee over the short-term employee. They also may benefit employees who are starting at an older age with a high salary and who intend to retire with the current employer. Defined-contribution plans, on the other hand, generally favor the younger employee over the older employee. Because of the portability of these plans, defined-contribution plan also benefit employees who have participated in 6

8 similar plans with previous employers and who wish to continue switching jobs as new opportunities arrive. Exhibit 1: Defined-Benefit vs Defined-Contribution Plan Plan type Defined-Benefit Defined-Contribution With employer and/or Mostly with employer Funding employee contribution plus resources investment income Investment risk Employer Employee Factors determining benefits Length of service, salary history, and multiplier E X A M P L E S Accumulated contribution and investment performance Corporate retirement plans 3M Bank of America Exxon Mobil Johnson & Johnson UPS Amgen Marathon Oil Proctor & Gamble United Airlines Southwest Airlines State employee retirement plans Oregon Public Employee Retirement System (PERS) Optional Retirement Plan (ORP) for Oregon public employees Teacher Retirement Optional Retirement System of Texas (TRS) Program (ORP) for Texas public education employees Florida Retirement System (FRS) Retirement Plan Investment Plan for Florida state employees Social Security 401(k)s and IRAs IIF. Comparison of Alternative Pension Plans All of these pension plans have several things in common. First, these are saving plans for rainy days. The accumulated money pays for all expenses when an individual leaves the active workforce and has no more paycheck or earnings on the way. They generate a highly predictable stream of cash flows upon retirement. Second, the plans provide tax incentives to save and invest. These arrangements allow an employee to save and invest now and pay (lower) taxes later. Third, the beneficiary individuals do not have unrestricted full access to the money in the plans because of the substantial tax penalty for early withdrawal and other restrictions imposed by the government and/or employer. 7

9 As such, all of the contribution is not part of the employees currently spendable wealth or liquid asset. However, these alternative pension plans serve their purpose and accomplish their objectives in different ways. For example, in a defined-contribution pension plan (including 401(k)s and IRAs), employees can periodically check the balance in a retirement account as employer and/or employee contributions to date are set aside and reinvested. On the other hand, in a defined-benefit pension plan (including Social Security plan), there is no way of knowing exactly how much is accumulated (except for employee contribution, if any) in the retirement account as the employer or Social Security Administration does not set aside money to be paid to the retiree upon retirement as an annuity or lump sum amount. What is interesting in the case of Social Security, employer and employee contributions in the form of Social Security taxes are used to calculate Social Security credit to be paid upon retirement. Part of a paycheck or earnings goes to generate Social Security benefit for retirement. Social Security taxes paid by the employer and employee and employer s promised contribution (payable upon retirement) and employee contribution, if any, to a defined-benefit plan are as much part of your earnings as employer and employee contributions to a defined-contribution plan. Let s use a hypothetical example to demonstrate that end results are identical under alternative pension plans although year-to-year balance in the account can be observed (and consequently be made subject to annual zakat in an inaccurate way) only in one of the two plans. Suppose that Mr. Yaqub worked for an employer for 25 years and lived another 15 years after retirement. His employer offered two alternative pension plans Plan A is a defined-contribution plan and Plan B is a defined-benefit plan. Mr. Yaqub chose Plan A and, based on the contributions plus investment income for 25 years, received a check for $444, upon retirement. Let s further assume that Mr. Yaqub has a solid portfolio of income generating assets and income from those assets plus his Social Security check would be sufficient to cover all his expenses for his remaining life of 15 years. He decided to invest the entire $444, in a shariah-compliant investment project earning an average rate of return of 0.5 percent per month and to donate the proceeds (i.e., initial investment plus income) to a charity at the time of his death. His investment will grow to [$444, x (1.005) 180 =] $1,090, in 15 years (or 180 8

10 months). If he would have chosen Plan B, his monthly retirement payment would have been calculated as follows: 1.5 percent multiplied by number of years of service and then multiplied by monthly salary in the last month of service. Assuming that Mr. Yaqub s salary in the last month of service was $10,000, his monthly pension income under Plan B would have been [1.5 percent x 25 x $10,000 =] $3,750. If each of his monthly pension check upon receipt was invested in the same investment as his lump sum amount of defined-contribution pension plan, his investment would have grown to [{( )/.005} x $3,750 =] $1,090, after 15 years. This example is presented in Table 1. Table 1: Defined-Contribution vs Defined-Benefit Pension Plan Cash Flows Alternative Pension Plans Defined- Contribution Defined- Benefit Balance at End Pension Payments Plan A Plan B Years of Employment Yr 1 $2, N/A Yr 2 $3, N/A N/A N/A Yr 25 $444, N/A Retirement Yr 1 $444, $3,750/month Yr2 0 $3,750/month 0 $3,750/month 0 $3,750/month Yr 15 0 $3,750/month Investment Value after 15 years $1,090, $1,090, It appears that the value of the investment after 15 years from retirement would be $1,090, for either plan. If both of these investments have identical terminal value (after 15 years of investment), their value at the beginning of investment (i.e., upon retirement) must be same. In other words, the present value at the beginning of retirement of his monthly pension income of $3,750 for 15 years must be $444,388.18, which is the lump sum amount he received in Plan A. As a matter of fact, there is no difference in substance in the benefits and only difference is in the form. However, the periodic balance in his retirement account (consisting of employer and employee contribution plus investment income to date) can de observed under Plan A but cannot be 9

11 observed in Plan B. The balance in his pension account at the end of each of 25 years of employment may be mistakenly considered part of his wealth or asset portfolio under Plan A and be subject to yearly zakat while showing no balance (or zakatable asset or wealth) in Plan B. In order to compare pension benefits from defined-benefit and definedcontribution pension plans, I intentionally constructed the example in a way to match pension income from Plan A with that from Plan B. In practice, pension benefits from alternative plans will be different. If return on investment in the financial market is high over the working life of the beneficiary, lump sum pension payment under definedcontribution plan will exceed the present value (at retirement) of all pension incomes under defined-benefit plan. If the investment income is low, the present value of definedbenefit pension incomes will exceed defined-contribution pension payment. In any case, employees can keep track of the yearly balance in a retirement account for a definedcontribution plan while no such yearly balance can be observed or estimated for a defined-benefit plan. This makes it harder to compare alternative plans on a yearly basis. Following the same logic, employee and employer payroll taxes toward Social Security retirement benefits, unlike for a defined-contribution Plan A, will not show any year-end balance (to be subject to zakat as wealth) until the employee starts receiving Social Security checks upon retirement. For the purpose of zakat calculation, all of these being part of employee s gross or total compensation and benefit package should be treated identically regardless of the timing and certainty or uncertainty of the cash flows. Moreover, similar to employee (and employer) Social Security taxes, deduction from employee s paycheck for contribution to a defined-contribution plan (and employer s matching contribution) are a form of involuntary employment or payroll tax. Like Social Security, these payments will be converted into pension benefits upon retirement. This arrangement is part of the employment contract and cannot be avoided while employed. Treating defined-benefit and defined-contribution plans differently for the purpose of zakat calculation on the basis of observable year-to-year retirement account balance will not be compatible with Islamic principles of fairness and equity. Furthermore, from a shariah perspective, there is an advantage of choosing definedcontribution over defined-benefit plan, if this option is available. The beneficiary 10

12 employee in a defined-contribution plan is responsible for selecting investment assets with the help of professional fund managers. He or she can design and invest in a portfolio of shariah-compliant securities using shariah stock screening tools available from Thomson Reuters-IdealRatings and Dow Jones Company. In a defined-benefit plan, the employer makes invest decision and usually selects the more conservative strategy of investing in interest-bearing (ribawi) fixed-income bonds, conventional mortgages and mortgage-related assets or aggressive strategy of investing in hedge funds and private equity. Hedge funds and private equity sell securities short (i.e., selling securities that one does not own), use arbitrage, trade mispriced securities, options and other derivatives, and invest in leverage buyouts and other speculative opportunities in any market. These transactions contain excessive uncertainty (gharar) and are not at all shariah-compliant. However, the employee does not make investment decisions in defined-benefit plans. It is better for an employee to avoid these plans if given a choice. III. Zakat on Alternative Retirement Plans For the purpose of determining when zakat is due on retirement plans, I classify all existing plans into two types mandatory and non-mandatory plans. Mandatory plans are sponsored by the employer or government and employees make mandatory pre-tax contributions through payroll deductions. These plans are part of the employment contract and included in the employee s total compensation package like other benefits such as health insurance and group life policies. Employees cannot accept the job without participating in these retirement plans. These plans are defined-benefit and definedcontribution plans and Social Security plan. Non-mandatory or optional plans are offered by employers as replacement for or supplement to mandatory plans or by financial institutions and an individual s participation is voluntary. However, there are tax incentives to participate in these plans. These are 401(k)s and IRAs. Individuals decide to participate in these plans by considering factors such as the availability of surplus funds after meeting current consumption and financial needs. These are comparable to other investment and financing decisions of individuals. It is argued that the participants do not have immediate and unrestricted full access to the funds in these plans because of tax penalties and restrictions on early withdrawal. However, the participants voluntarily accept these 11

13 restrictions and decide to trade current consumption for future consumption upon retirement. Investors always accept similar restrictions in other investment assets for tax reason. For example, investors often delay realizing capital gain on stocks to avoid paying capital gain taxes in the current year, temporarily sacrifice liquidity (i.e., cash from sale proceeds to be spent immediately) and thereby reduce potential tax liability in present value. There are some minor differences of opinion among Muslim jurists and shariah scholars regarding zakat on alternative retirement plans. Al-Qardawi (1999) very eloquently stated this as follows: A question which commonly arises these days concerns retirement savings and pension contributions that are retained by governments, employers, or other independent agencies to which the contributor has no direct access, except upon retirement or termination of employment. The zakat on such funds is determined by whether they can be defined as being completely owned by the contributor. Can he dispose of them at will or not? Are these funds the right of the contributor or mere contributions whose value will be determined at the time of retirement? If they are purely contributions or gifts, they accrue only to the contributor at the time of receipt. But if they are part of what the contributor has access to and may dispose of at will, then they should be treated like debts owed by people who are capable and ready to pay, i.e. they are subject to zakat every year, once they reach the nisab for zakat. Al-Qardawi (1999) also cited Imam Malik's view on debts. According to Imam Malik, zakat on debts is not due until they are received, and then zakat is due on them once in the year of receipt. Rehmani (1983) discussed opinion of Imam Abu Hanifa and his two disciples: Imam Abu Yousaf and Imam Muhammad. Imam Abu Hanifa s opinion is that one has to pay zakat after receiving the amount and after the time of one year has passed. Imam Abu Yousaf and Imam Muhammad differ with Imam Abu Hanifa and they are of the view that one has to pay zakat on the full amount even before the amount is received by the person. Based on their view, zakat is due on the full amount for each year of service. 12

14 The views expressed in Usmani and Qazi (2010) and Kahf (2002) are consistent with Al-Qardawi (1999). Usmani and Qazi (2010) pointed out that the subject matter of zakat must be in the complete ownership of the (zakat) payer. If someone possesses an asset but does not own it, zakat is not due on it. Kahf (2002) pointed out that ownership is one of the five conditions required by Muslim jurists for an asset to be subject to zakat. The author s view is that for an item to be subject to zakat, it must be owned by the potential (zakat) payer. This ownership must complete, absolute and not restricted (except, obviously as the law provides) so that it gives the owner all the power she or he is entitled to by the law. He added that the application of this requirement excludes assets or properties to which the owner has no accessibility. He cited as an example a mandatory retirement plan held and managed by other than the owner whereby the owner has no way to benefit from it up until retirement. IIIA. Zakat on Mandatory Plans It is apparent that the majority of Muslim jurists and shariah scholars consider employer-sponsored mandatory retirement plan income subject to zakat only upon receipt at the time of retirement, provided that the requirement of nisab is fulfilled and one Islamic lunar year (hawl) has passed. No zakat is payable for preceding years. These are the funds that Al-Qardawi (1999) categorized as employees having no direct access to until retirement. This applies to employer-sponsored mandatory defined-benefit and defined-contribution plans. It makes no difference whether year-end balance is being observed and can be estimated during each year of employment (as in case of definedcontribution plan) or no balance shows up year after year nor can be estimated up until retirement (as in case of defined-benefit plan). Automatic payroll deduction in the form of contribution to retirement account is a tax and cannot be avoided. If the employer offers a retirement plan, employee contribution is automatically deducted from paycheck. That makes the deduction look like Social Security or payroll taxes and not be subject to annual zakat until received upon retirement. A similar view is expressed by a leading contemporary shariah scholar, Mufti Mohammad Taqi Usmani, in a contemporary ruling (fatawa): If the salary of the employee is deducted at source, without giving this amount to the employee, zakat is not payable on the amount kept in the 13

15 retirement account, until the employee receives the same. When an employee receives it on his retirement, the amount so received shall form part of his zakatable assets of that year only, and such part of it, that is not spent before the valuation date, shall be subject to zakat, and zakat will be payable on the aggregate balance of his assets (including the balance of the amount received from the fund) on the valuation date. (Usmani and Qazi, 2010). Now I want to raise a question that has not yet been brought to the attention of contemporary Muslim jurists and shariah scholars by anyone. Continuing the example of Mr. Yaqub, instead of assuming that his income from other assets plus his Social Security check would be sufficient to cover all his expenses for his remaining life of 15 years, let s assume that he has to live on his pension check during his retired life. As Mr. Yaqub had chosen defined-contribution pension plan, he will pay zakat on the single check of $444, at the end of zakat cycle of one Islamic lunar year (hawl). What if he had chosen defined-benefit plan and instead of receiving a single check, he continues to receive until death monthly pension check of $3,750 as we figured out earlier? Al- Qardawi (1999) discussed in detail the rationale for calculating zakat on income along the line of taxes on income and profit. He stated that income from wages, salaries and professional fees has a zakat rate of 2.5 percent, in application of general rule that zakat rate on money, whether it takes the form of assets or income, is 2.5 percent. Accordingly, Mr. Yaqub will pay zakat equal to 2.5 percent of total annual net income from pension (i.e., pension check minus allowable basic necessary expenses such as food, clothing, accommodation, education, transportation and medical expenses) exceeding nisab. If Mr. Yaqub had chosen defined-benefit plan (Plan B), he would pay less zakat than defined-contribution plan (Plan A). In Plan A, after one Islamic lunar year, he will pay zakat on lump sum pension benefit of $444, (after deducting allowable yearly expenses) and other zakatable assets, if any, exceeding nisab. He will continue paying zakat on his wealth exceeding nisab which will include declining balance of initial pension benefit of $444, On the other hand, under Plan B, his monthly pension benefit for the year minus allowable annual expenses will be subject to zakat if his savings from pension benefit along with other zakatable assets, if any, exceeds nisab. Unlike the defined-benefit plan, he will carry forward a large balance from initial lump sum amount in the defined-contribution plan resulting in a higher amount of zakat than under 14

16 defined-benefit plan without any lump sum to be carried forward. This possibility of paying lower zakat under defined-benefit plan will give employees incentive to prefer defined-benefit over defined-contribution plan when this option is available. In almost all public institutions and some corporations, employees can choose between defined-benefit and defined-contribution plan. This may open the door for shariah-arbitrage, i.e., selecting pension plan to maximize materialistic after-zakat cash flows. It is extremely important for contemporary Muslim jurists and shariah scholars to address this matter urgently and issue a ruling (fatawa) treating participants of defined-benefit and definedcontribution retirement plan in a fair and equitable way and to close the door for shariah-arbitrage. Moreover, by choosing defined-contribution over defined-benefit plans, an employee can avoid interest-bearing (rebawi) securities and guaranteed investment scheme (GIC), and securities with excessive uncertainty (gharar) that the employer picks for a defined-benefit pension plan. The employees participating in a defined-contribution plan can work with employer-designated investment houses to put pension money in shariah-compliant assets such as Amana mutual funds (Amana Income, Amana Growth, and Amana Developing World Fund), Azzad funds (Azzad Wise Capital, and Azzad Ethical Fund), and Iman Fund. IIIB. Zakat on Non-Mandatory Plans There is consensus among Muslim jurists and shariah scholars on whether zakat is due annually on voluntary retirement plans before the participant receives the funds from the account upon retirement. Most of the scholars consider these funds subject to zakat during each year of employment as long as the total amount reaches the zakat threshold (nisab). Kahf (2007) included funds accumulated in IRAs account, 401(K)s, and similar individual or employer-sponsored retirement accounts among the examples of zakatable items for Muslim Americans. These are the funds that Al-Qardawi (1999) classified as employees having immediate access to and ability to dispose of at will any time before retirement (of course, subject to penalty and taxes). These are similar to money lent to others that are expected to be repaid and zakat is due on such outstanding loans each year until paid off. Usmani and Qazi (2010) cited Mufti Mohammad Taqi Usmani s view on this: If the employee first receives the amount and then with his own intention, puts the money in the retirement account, then this money will become the 15

17 subject matter of zakat and zakat will be obligatory for all the years in which the money is kept in the fund. Some Muslim jurists and shariah scholars suggest that zakat is due not on the full balance of the account, but on the amount that is available after deducting applicable taxes and early withdrawal penalty on the balance. If the terms and conditions of the plan do not allow early withdrawal of accumulated matching employer contribution, if any, and reinvestment income of the funds, then zakat will be due only on the amount the participant will receive in early withdrawal minus applicable taxes and penalty. This has been suggested by Dr. Salah Al-Sawy, secretary general of the Assembly of Muslim Jurists in America (AMJA) [Zakat Foundation of America, 2007]. For the purpose of zakat, these plans are treated as other voluntary investment assets of the participants. However, some Muslim jurists and shariah scholars allow delaying zakat on the amount until retirement as delaying zakat is acceptable and at that time zakat is due for all the years until retirement. This is because it s permissible to pay the zakat due on an item out of that item and you are not required, though permitted, to pay it out of other resources (Kahf, 2004). However, this will impose a major drag on the employee s cash resources upon retirement when his or her paycheck or income stops coming. It is better to pay zakat annually on non-mandatory pension funds if funds are available. IIIC. Zakat on Social Security Benefit As discuss previously, Social Security benefit is a defined-benefit plan with pension benefit estimated using a statutory formula that takes into account factors such as age at the time of retirement, the number of years Social Security taxes paid, and the amount of taxes paid. Anyone paying Social Security taxes in the form of automatic payroll deduction does not have access to the fund until retirement and very few wage-earners are exempt from these taxes. On the basis of opinion of Muslim jurists and shariah scholars, we established that mandatory pension plans (defined-benefit as well as defined-contribution) are subject to zakat upon receipt of benefit at retirement. Following the same principle, Social Security program being a defined-benefit plan that requires mandatory participation for nearly all workers, zakat on Social Security benefit is due only upon retirement. This is consistent with the view expressed in Kahf (2007). As the beneficiary begins receiving Social Security check monthly, zakat should be due at the end of an Islamic lunar year upon retirement if nisab is exceeded. 16

18 There is a program called integrated pension plan where employer s pension and Social Security benefits are combined to create an integrated retirement scheme. Integration scheme is intended to let employer avoid making double contribution to employee s retirement in the form of funding retirement plan and paying Social Security taxes. Integration involves mostly defined-benefit plans and integration involving defined-contribution plans is rare. For example, the Massachusetts State Employee Retirement System (MSERS) is an integrated retirement scheme and is called a definedbenefit program in lieu of Social Security (Massachusetts State Retirement Board, 2013). Eligible employees do not pay Social Security taxes and may have his or her Social Security benefits offset in a variety of circumstances. For an integrated retirement scheme, zakat is calculated for combined retirement and Social Security incomes only when benefits are received, provided the condition of nisab and hawl are satisfied. IV. Concluding Remarks Pension plans are extremely important in the life of any individual. They provide disposable income when workers leave the active workforce and stop earning income. For Muslim Americans, these plans have added importance in terms of possible obligation to pay zakat on the balance. This paper discusses alternatives pension plans in terms of their source of funding and investment risk. Based on opinion of Muslim jurists and shariah scholars, we concluded that plans offered by employers as a part of compensation and benefit package for a job with mandatory employee participation are subject to zakat when money is received upon retirement and plans offered as replacement for or supplement to employer-sponsored plans with voluntary employee participation are subject to zakat each year after taking into consideration taxes and penalty for early withdrawal. It makes no difference for zakat purpose if balance in the retirement account is observed at the end of each year of employment or no balance can be estimated until retirement. We found out that there is an unanswered question as to how zakat should be calculated on employer-sponsored mandatory defined-benefit plans to treat them at par with employer-sponsored mandatory defined-contribution plans. 17

19 References Al-Qardawi, Yusuf (1999). Fiqh-az-Zakat: A Comparative Study. English Translation by Monzer Kahf. London, Dar Al Taqwa. Kahf, Monzer [Ed.] (2002). Economics of Zakah: A Book of Readings (2 nd Edition). Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia. Kahf, Monzer (2004). Fatawa Zakah Retrieved from Kahf, Monzer (2007). The Calculation of Zakah for Muslims in North America (4 th Electronic Edition). Massachusetts State Retirement Board (2013). Benefit Guide for the Massachusetts State Employees Retirement System. Boston, Massachusetts. McWhinney, James E. (2009). The Demise of the Defined-Benefit Plan. Retrieved from McWhinney, James E. (2011). Introduction to Social Security. Retrieved from Oregon University System (2014). Decision Making Guide: Optional Retirement Plan Public Employee Retirement System. Corvallis, Oregon. Rehmani, M. Saifullah (1983). Fiqhi Masaail. Lahore, Pakistan, Habib Shafiq Book Depot, cited in Nazir, Naila (2009). Zakat on General Provident Fund: Misconception or Avoidance. Journal of Managerial Sciences, 3(2). Sabiq, As-Sayyid (1991). Fiqh us-sunnah: az-zakah and as-siyam. English Translation by Abdul-Majid Khokhar, Muhammad Saeed Dabas, and Jamal al-din M. Zarabazo, Indianapolis, Indiana, Amana Trust Publications, Vol. 3. Social Security Administration (2014). Social Security Understanding the Benefits. Washington, D. C. Texas Higher Education Coordinating Board (2013). An Overview of TRS and ORP. Austin, Texas. Usmani, Muhammad Imran Ashraf, and Qazi, Bilal Ahmad (2010). Guide to Zakah: Understanding and Calculation. Karachi, Pakistan, Meezan Bank Limited. Zakat Foundation of America (2007). The Zakat Handbook: A Practical Guide for Muslims in the West. Worth, Illinois. 18