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Is a RMD considered earned income?

Retirement accounts help you save for your future, manage your taxable income and shelter your investment earnings from taxes—at least temporarily. But the IRS doesn't allow you to protect your hard-earned savings from taxation indefinitely. Instead, you must withdraw funds from most qualified retirement accounts at a certain point due to required minimum distribution (RMD) rules.

When you withdraw those funds, you generally owe taxes on them, but why? Is a RMD considered earned income? How is that possible when you're being "forced" to take the withdrawal? And what can you do with the funds if you don't need the money?

How do RMDs work?

The IRS requires you to take RMDs from certain retirement accounts—typically pretax individual retirement accounts (IRAs) and employer plans like 401(k) and 403(b) plans—if you reach age 72 in 2022 or earlier (born in 1950 or earlier), there is no change to RMD start age. If you were born 1951-1959, you can delay until age 73. If you were born in 1960 or later, your RMD start age is 75. You must withdraw a certain amount from these accounts each year, and the RMD is the minimum amount permitted (you are, of course, allowed to take more than your RMD).

Ultimately, RMDs are designed to draw down all of your assets over your remaining lifespan, so it's typically based on your account balances at the end of the previous year, and your age in the current year. The IRS provides worksheets and tables to help you calculate your RMD. However, you might not need to calculate RMDs yourself. In many cases, your investment providers or custodians can provide calculations for you.

RMDs hover just below 4% of your year-end account balance—but that percentage grows over time. You can use the IRS' Uniform Lifetime Table to help calculate your RMD.

The tax rules for RMDs are complicated, and they change periodically, so review your situation regularly with a tax expert.

Are RMDs considered earned income?

In short, no—neither a RMD nor any other distribution plan is considered earned income. However, the IRS treats RMDs as ordinary and therefore, taxable income.

As mentioned, the point of RMDs is to remove funds from tax-protected accounts. And in many cases, you didn't pay federal income tax on that money, so RMDs force you to report the income you previously deferred. Ultimately, RMDs generate revenue for the U.S. Treasury.

What if you fail to take an RMD?

The IRS imposes steep penalties for missing an RMD, so it's critical to take them each year. The missed RMD penalty is 25% starting with 2023 RMD and is dropped to 10% if fixed during the correction window. That is an unnecessary cost that can take a big bite out of your retirement savings, so consider ways to avoid that penalty. For example, you might be able to automate RMDs, or you can set up reminders on your calendar every year. No matter what approach you take, be sure you're on top of these withdrawals.

What if you don't "need" the money from required minimum distributions?

Bear in mind that just because you are required to withdraw money from your retirement plan, you don't have to spend it. If you feel stable in managing your day-to-day retirement finances, here are some other savvy uses for your RMD.

1. Reinvest it. You don't have to stop investing just because you take an RMD. You could consider moving your RMD directly from your retirement account to a taxable brokerage account. Within that account, you can reinvest your RMD in a way that's aligned with your goals.

2. Pass it along. If you're planning to help someone pay for education expenses, it might make sense to fund a 529 plan. If you contribute your RMD to a child or grandchild's 529 account, you'll pay income tax on the RMD, but the money you invest in the 529 account will grow tax-deferred.

3. Donate to charity. You can complete a qualified charitable distribution (QCD) by transferring RMD funds (up to a maximum of $100,000 per year) directly to a qualifying charity. In some cases, this strategy can provide a bigger tax benefit than donating cash directly from your bank account. However, it also can be complicated, and missteps can result in unexpected taxes.

Ultimately, you have various ways to put your RMD money to work if you don't need the funds for everyday living expenses. But each option has pros and cons, and the tax rules are complicated. To minimize problems, work closely with a tax professional who is familiar with your situation.

The bottom line

RMDs are a fact of life when you save for retirement in pretax accounts. Like birthday cake, the IRS doesn't want you to have too much of a good thing, so eventually, you need to pay taxes that you previously avoided. You simply can't avoid RMDs, and if you don't need the money, shifting funds is a matter of strategy and logistics.

It's wise to execute any changes with professional help, though, so speak with a financial advisor who can help you explore options for your annual RMD withdrawals.

Investing involves risks, including the possible loss of principal.   

529 plans are offered through a brokerage arrangement with Thrivent Investment Management Inc. 529 college savings plans are not guaranteed or insured by the FDIC and may lose value. Consider the investment objectives, risks, charges, and expenses associated before investing. Read the issuer’s official statement carefully for additional information before investing. Investigate possible state tax benefits that may be available based on the state sponsor of the plan, the residency of the account owner, and the account beneficiary. Consult with a tax professional to analyze all tax implications prior to investing.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.