What Is Ordinary Income?
Ordinary income is any type of income earned by an organization or individual that is taxable at ordinary rates. It includes but is not limited to wages, salaries, tips, bonuses, rents, royalties, and interest income from bonds and commissions. Long-term capital gains, or the increase in the value of investments owned for more than a year, as well as qualified dividends are taxed differently and therefore not considered to be ordinary income.
- Ordinary income is any type of income that's taxable at ordinary rates.
- Long-term capital gains and qualified dividends are not considered ordinary income, as they are both taxed differently.
- In a corporate setting, ordinary income comes from regular day-to-day business operations, excluding income gained from selling capital assets.
- For private individuals, ordinary income usually consists of the pretax salaries and wages they have earned.
Understanding Ordinary Income
Ordinary income comes in two forms: business income and personal income. In a corporate setting, the term refers to any type of income generated from regular day-to-day business operations, excluding any income earned from the sale of long-term capital assets, such as land or equipment.
Meanwhile, from a personal perspective, ordinary income can be defined as any kind of cash inflow that is subject to income tax, as outlined by the Internal Revenue Service (IRS).
Examples of Ordinary Income
For private individuals, ordinary income typically consists of the salaries and wages they earn from their employers before tax. If, for example, a person holds a customer service job at Target and earns $3,000 per month, their annual ordinary income can be calculated by multiplying $3,000 by 12.
If this customer service employee has no other income sources, $36,000 is the amount that would be taxed on their year-end tax return as gross income. Alternatively, if the same person also owned property and earned $1,000 a month in rental income, their ordinary income would increase to $48,000 per year.
For businesses, ordinary income is the pretax profit earned from selling its product(s) or service(s). Retailer Target made $75.4 billion in total revenue in the year ending Feb. 2, 2019.
However, those sales cost money to generate. The company claimed the costs attributable to the production of goods sold (COGS) was $53.3 billion. Target also said it forked out $15.7 billion on selling, general, and administrative expenses (S&GA). Factor in depreciation and amortization as well, the loss of value of its tangible and intangible assets, and you get an ordinary income of $4.1 billion. This is the amount of income that Target will be taxed on for its fiscal year.
Ordinary income can only be offset with standard tax deductions, while capital gains can only be offset with capital losses.
To encourage people to invest in the long term, the government taxes capital gains and common stock dividends at a lower rate than ordinary income. Dividends were taxed as ordinary income—up to 38.6%—until the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) was enacted, reducing the tax on most dividend income, along with some capital gains, to 15%. Those changes encouraged investing and prompted companies to increase or begin paying dividends.
At the end of 2017, President Trump signed the Tax Cuts and Jobs Act into law, which changed the tax rate on qualified dividends (see below) to 0%, 15%, or 20%, depending on an individual's taxable income and filing status.
Qualified vs. Unqualified Dividends
Investors should be aware that not all dividends qualify for favorable tax treatment. Examples of unqualified dividends include those paid out by real estate investment trusts (REITs) and master limited partnerships (MLPs), income paid on employee stock options (ESO), as well as dividends paid by tax-exempt companies and on savings or money market accounts.
Another thing to watch out for is eligibility requirements. Regular dividends paid out to shareholders of for-profit companies usually qualify for taxation at the reduced capital gains rate. However, investors must adhere to minimum holding periods to take advantage.
For common stock, a share must be held more than 60 days of the holding period, the 120-day period that begins 60 days before the ex-dividend date. For preferred stock, the holding period is longer, beginning 90 days before the company's ex-dividend date.