Investing in a Roth IRA is only permissible as long as your contributions are not going to interest based investments (such as bonds) or Haram companies (companies involved in gambling, alcohol etc.)
Investing is key to increasing your wealth in the future. Like many do in North America, leaving money in a savings account and waiting till you’re older to reap the reward is a bad plan. This is because of inflation, your money in the bank account is worth less as time passes by.
Here’s a quick example to show you why you should invest your money and not leave it in a savings or chequing account. If you had $10,000 in your chequing account back in 2010, it is probably worth $8,100.30 in todays money (source). Your bank account will still show $10,000, but your purchasing power is much less than now. Things become more expensive as time passes and never the other way around.
This is why investing is key to financial freedom. Like many other muslims living in North America or Europe, you may be thinking that investing in a Roth IRA or 401K is Haram because not all companies are halal outside of muslim countries. Well that’s definitely not the case and there are ways around this. This is what we’d like to clarify in this post
Table of Contents:
1. What’s the Difference Between A Roth IRA & A 401k
What is a Roth IRA?
What is a 401K ?
Difference between Roth IRA and 401K
2. Islamic Ruling on 401K, ROTH IRA, & RRSP Investing
3. Halal Ways To Invest In Halal IRA or 401k
Self Directed IRA or Solo 401K Plan
Tailoring A Plan With An Employer to Invest In Islamic Approved Mutual Funds
What’s the Difference Between A Roth IRA & A 401K
Before looking at the difference between them, let’s touch base on what a Roth IRA and a 401K are.
What is a Roth IRA?
A Roth IRA is an Individual Retirement Account that you put money into and withdraw tax free (as long as certain conditions are met). The money you use to fund your Roth IRA account are after-tax. The money you invest goes into a mix of 3 different investments.
- Mutual Fund (A a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets (source))
- ETFs (exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock. (source) )
As time goes by your account grows thanks to compound interest and hopefully the stocks and other investments do well. However you can only withdraw your money at the age of 59 and a half (source). If you withdraw money from before that, you will be taxed by the IRS.
Remember, limits to contributions do apply.
What is a 401K ?
A 401K is offered by many employers. The government allows companies to offer its employees retirement savings accounts with some tax advantages (the purpose of this is to motivate people to save for their retirement). People invest in a 401K because of the tax incentives. Here’s how it works.
- A small amount from your paycheck is automatically deposited to your 401K account.
- Since your take home salary has been deducted because of the contributions, you’re taxed less.
- The money in the 401K account grows tax free. You only get taxed when withdrawing the money (even after turning 59 and a half).
Here’s a quick example to make it easier to understand. If you earned $100,000 in a year, but invested a total of $10,000 into your 401K, you only get taxed on $90,000 since that was your take home money. This way you pay less tax. Furthermore, that $10,000 you invested can grow tax free.
Similar restrictions apply when withdrawing that money. You must be 59 and a half to withdraw money from your 401K. If you withdraw money from it before that age, you’ll pay income tax and a penalty (unless you qualify for specific exceptions). However, even when withdrawing the money after that age, you’ll still pay some taxes.
Some companies offer 401K matching. This means if you contribute $100 into your 401K, they’ll also add $100 to your 401K. Check with your employer as to how much they’ll match your contributions.
We strongly recommend that you speak with a Tax professional to choose which option is right for you
Difference between Roth IRA and 401K
Here are the differences between a Roth IRA and a 401K
- Contributions made from a ROTH IRA are post-tax, whereas 401K contributions are pre-tax.
- Some companies offer 401K matching. We’re not aware of a roth IRA matching program.
- At the age of 59 and a half, you don’t pay taxes when withdrawing money from your Roth IRA. With a 401K, you will pay some taxes.
Reminder: We are not investing professionals and we recommend you to do your research and seek advice from financial experts.
Islamic Ruling on 401K, ROTH IRA, & RRSP Investing
We did some research on this topic and sourced information from the experts. Staring off with Mufti Muhammad Ibn Muneer. He completed his masters in Hadith from the university of Madinah to pursue his islamic education. Mufti completed his masters in Hadith and is currently pursuing his PhD (source).
He states that 90% of the time, the money people contribute to their 401K, ends up being invested in haram stocks or companies that they might not know about. The lack of knowledge on where the contributions are going makes it too risky and most likely haram (source).
Investing in companies in the following industries are known to be haram and are known to be non permissible for muslims (source):
- Adult entertainment
- Pork products
- Interest-based businesses
- Music, cinema or broadcasting
- Highly leveraged businesses
He makes a compelling point that some employees working at specific companies are able to ask about the stocks and mutual funds and request that it be invested in more halal-friendly companies (source).
Interest is another point he makes, if the contributions you make end up making you more money but from interest (this typically happens when the 401K contributions end up being invested in bonds which yield a positive return from interest), then that is considered haram.
Here’s what he had to say:
Halal Ways To Invest In Halal IRA or 401k
Here are 2 different ways you can invest in a halal Roth IRA or 401K
1- Self Directed IRA or Solo 401K Plan
The U.S Retirement system allows anyone to use a self-directed IRA or Solo 401K plan (source). This allows muslims to to gain control over their retirement account and avoid investing in haram investments (companies involved in alcohol or gambling, interest yielding investments etc).
Through a self directed IRA or Solo 401K plan, muslims can avoid interest yielding investments by structuring their retierment plan to invest in real estate or debt related investments so that it is compliant with Sharia law (source). For example, instead of investing in bonds, muslims can invest in real estate and be rewarded with a share from the profit gained from the asset (source).
2- Tailoring A Plan With An Employer to Invest In Islamic Approved Mutual Funds
Companies like Wealthsimple or Saturna Capital have halal and Islamic certified mutual funds. While most people contribute funds to their islamic approved mutual funds after recieving their salary, having a conversation with your companies HR to request that they place funds in similar mutual funds (so that you can still enjoy tax and matching benefits) is a great way to increase your principal contributions in your investments.
Investing, generally speaking, is a tricky subject and many muslims and scholars have different opinions. Whether that be investing in cryptocurrency, stocks, or Roth IRAs.
The principal of investing is generally agreed upon among islamic scholars to be permissible, however the issue with investing in regular 401K and Roth IRAs is that your contributions gets lumped up with investments made to haram categorized companies or bonds (which is purely interest based).
This topic really requires research and we strongly encourage you to do further research into the topic and get advice from islamic financial experts who may have other advice on how you should proceed depending on your situation.