Do Required Minimum Distributions Count as Earned Income?
Learn why RMDs are considered ordinary income, not earned income, and how this affects your IRA contributions and the taxation of your Social Security benefits.
Retirees often manage multiple income streams, leading to confusion about how each is classified for tax purposes. A common point of uncertainty is the nature of Required Minimum Distributions (RMDs) from retirement accounts. Understanding this distinction is important for proper tax planning and compliance during retirement. This guide clarifies how RMDs are defined and treated by tax authorities.
Defining Earned Income vs. RMDs
The Internal Revenue Service (IRS) provides a specific definition for “earned income.” This category includes compensation from active work, such as wages, salaries, tips, commissions, bonuses, and net earnings from self-employment. If you perform a service to generate payment, it is considered earned income.
A Required Minimum Distribution, or RMD, operates under a different framework. An RMD is a mandatory annual withdrawal that individuals must take from most tax-deferred retirement accounts, like traditional IRAs and 401(k)s, once they reach a certain age. For individuals born between 1951 and 1959, this age is 73, and for those born in 1960 or later, it is 75.
These withdrawals are not compensation for work; they are distributions of funds that have been accumulating with tax-deferred growth. Because RMDs are withdrawals from savings, they do not meet the IRS definition of earned income and are instead classified as unearned income, similar to interest or dividends.
Tax Treatment of Required Minimum Distributions
A Required Minimum Distribution is taxed as ordinary income. This means the amount you withdraw is added to your other income for the year and taxed at your standard federal and state income tax rates. The funds were originally contributed on a pre-tax basis, and the growth was tax-deferred, so the IRS requires taxes to be paid when the money is finally distributed.
Your financial institution or account custodian reports this distribution to both you and the IRS. You will receive a Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form details the gross distribution amount and any taxes withheld, which is necessary for your tax return.
The taxability of an RMD depends on the retirement account from which it is withdrawn. For traditional, pre-tax accounts like a 401(k) or traditional IRA, the entire RMD amount is taxable. An exception exists for RMDs from an inherited Roth IRA, as these qualified distributions are often tax-free to the beneficiary.
Key Financial Implications of the Distinction
The classification of RMDs as unearned income has significant financial consequences. One of the most direct impacts is on your ability to contribute to an Individual Retirement Account (IRA). To make contributions to either a Traditional or Roth IRA, you must have earned income, so you cannot use RMD funds for this purpose.
This distinction also affects the taxation of your Social Security benefits. The IRS uses a calculation called “combined income” to determine if a portion of your Social Security is taxable. Combined income includes your adjusted gross income (AGI), nontaxable interest, and half of your Social Security benefits. Because RMDs are included in your AGI, they increase your combined income, which can push you over the threshold where your benefits become taxable.
RMDs as unearned income means they cannot be used to qualify for certain tax credits. For example, the Earned Income Tax Credit (EITC) is designed for individuals with low-to-moderate earned income. Since RMDs do not qualify, they may, by increasing AGI, disqualify you from other income-based credits.