Summary: Take responsibility for your future by leveraging your employer’s 401(k) program and/or opening an Individual Retirement Account (IRA). Understand the tax benefits, contribution limits, and withdrawal rules to decide which specific type of account is best for you.
“Should I bother saving for retirement? Won’t my kids take care of me when I’m old? It’s their duty, after all. Surely, I’ll get a nice Social Security payout. Heck, I don’t even know if I’ll live to see retirement. Anyway, even if I do, Allah (SWT) is the Provider, and He will provide for my needs.”
Those are all fair questions and thoughts, but then again, so are these: What if your grown kid moves overseas for an exciting job opportunity? What if the government decides to defund its Social Security program? What if you live to be 100 years old?
When Prophet Muhammad (PBUH) saw a Bedouin walking away from his camel without tying it, he said: “Why don’t you tie down your camel?” The Bedouin answered, “I put my trust in Allah.” To which The Prophet replied, “Tie your camel first, then put your trust in Allah.” (Narrated by al-Tirmidhi).
None of us knows what the future holds, but I’m a firm believer that one should hope for the best and prepare for the worst. One should take responsibility for his/her future and tie his/her camel.
How does one go about preparing for retirement? Social security programs and pensions aside, for residents of the U.S. there are two primary methods you can use to take charge of your own retirement planning: a 401(k) and an Individual Retirement Account (IRA).
If you work for a company, it may or may not offer a 401(k). This is a program in which you elect a percentage of your paycheck to be deducted and put straight to your 401(k). It’s a way of paying yourself first, and you won’t be taxed on that money until you retire and begin withdrawing money. As of the date of writing this article, the IRS allows individuals to contribute up to $19,500/year to a 401(k), or $26,000/year if they’re age 50 or older.
The upsides of a 401(k) include the tax benefit, the convenience of having money automatically invested, and a possible company contribution towards your 401(k).
Downsides include limited investment choices (which may or may not be Shariah-compliant; that is, Islamically permissible), excessive management fees by the 401(k)-program administrator, and the inability to access the money until after you retire.
An IRA (Individual Retirement Account), on the other hand, is managed entirely by you. This is a good option if you’re self-employed or if your employer doesn’t offer a 401(k). You can open an IRA with a brokerage firm, a mutual fund company, or a bank. After opening the account and adding money to it, you can choose exactly where to invest the money. This is great for Muslims and others who want to invest in an ethical manner since the investor can choose where his/her money is invested. Like a 401(k), an IRA also offers a tax benefit and has restrictions on withdrawing money prior to reaching a certain age.
There are two main types of IRAs: Traditional and Roth. The main difference between the two is when tax obligations occur. With a Traditional IRA, you realize tax benefits right away since the amount of money you contribute to an IRA is tax-deductible. Put differently, your taxable income is reduced by however much you contribute to an IRA.
After retiring, withdrawals from a Traditional IRA are considered income and you’ll have to pay taxes on these withdrawals.
On the other hand, with a Roth IRA, contributions are not tax-deductible so you pay taxes on that money now. The perk is that after you retire and make withdrawals you won’t owe any taxes on these withdrawals.
There are some other rules to consider. The IRS allows individuals to contribute $6,000/year to an IRA, or $7,000/year if they’re age 50 or older. If you happen to have both a Traditional and Roth IRA, this annual limit applies across all of your IRAs.
When it comes time to retire and withdraw some of that hard-earned cash, you can choose what percentage of the account you want to withdraw annually. While there’s no set rule about this, 4% is often touted as the golden number if you want your savings to last more than 25 years. The rest of the money remains in your account and continues to grow.
Note that you can’t begin taking distributions until you reach age 59½ without incurring a penalty. If you like, you could even leave the money alone and let it grow even more before taking distributions at an older age. However, with a Traditional IRA or a 401(k), the IRS mandates that you begin withdrawing money by age 72.
Going back to the original question of whether to use a tax-advantaged account and save for retirement, the tax benefits alone make a 401(k) or IRA appealing. Aside from the tax benefits, the penalties that are enforced on early withdrawals from tax advantaged accounts can help savers maintain discipline while they prepare for their futures.