What Is Ordinary Income?
Ordinary income is any type of income earned by an organization or an individual that is taxable at ordinary rates. It includes (but is not limited to) wages, salaries, tips, bonuses, commissions, rents, royalties, short-term capital gains, unqualified dividends, and interest income.
- Ordinary income is any type of income that’s taxable at ordinary rates.
- Examples of ordinary income include salaries, tips, bonuses, commissions, rents, royalties, short-term capital gains, unqualified dividends, and interest income.
- For individuals, ordinary income usually consists of the pretax salaries and wages they have earned.
- In a corporate setting, ordinary income comes from regular day-to-day business operations, excluding income gained from selling capital assets.
Understanding Ordinary Income
Ordinary income comes in two forms: personal income and business income.
Personal ordinary income can be defined as any kind of cash inflow that is subject to the standard marginal income tax rates, as outlined by the Internal Revenue Service (IRS).
For businesses, on the other hand, 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.
Long-term capital gains and qualified dividends are taxed differently and not considered to be ordinary income.
Examples of Ordinary Income
Let’s take a look at how ordinary income works for individuals and businesses in the following examples.
For private individuals, ordinary income typically consists of the salaries and wages that they earn from their employers before taxes. If, for example, a person holds a customer service job at Target and earns $3,000 per month, then their annual ordinary income can be calculated by multiplying $3,000 by 12.
If this customer service employee has no other income sources, then $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, then 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 $78.1 billion in total revenue in its fiscal year (FY) ending Feb. 1, 2020. However, those sales cost money to generate.
The company claimed that the costs attributable to the production of goods sold (COGS) were $54.9 billion. Target also said it forked out $16.2 billion on selling, general, and administrative expenses (SG&As). Factor in depreciation and amortization as well, and you get an ordinary income, or operating income, of $4.66 billion. This is the amount of income that Target was taxed on.
To encourage people to invest long term, the government taxes profits on investments sold after more than a year and most stock dividends held beyond a certain period at a lower rate than ordinary income.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced the tax on most dividend income, along with some capital gains, to 15%. Those changes encouraged investing and prompted companies to increase dividends or begin paying dividends instead of holding onto their cash.
At the end of 2017, then-President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) 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), income paid on employee stock options (ESOs), and dividends paid by tax-exempt companies and on savings accounts 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, but investors must adhere to minimum holding periods to take advantage.
For common stock, a share must be held for more than 60 days during the 121-day holding 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.
What Is Taxed as Ordinary Income?
Most of the income you make will be taxed at the regular marginal tax rates. There are exceptions, though, including for long-term capital gains and qualified dividends, which are both taxed at more favorable rates. If you're not sure how a certain source of income is taxed, it might be wise to contact the IRS or a tax professional.
Is Rent Ordinary Income?
Rental income, defined by the IRS as “any payment you receive for the use or occupation of property” is generally taxed as ordinary income. However, you can deduct certain costs from this income to reduce the figure at which the IRS taxes you. Deductible expenses include mortgage interest, property tax, repair costs, advertising, maintenance and cleaning, condo fees, and homeowners insurance.
Do I Have to Report Interest Income?
Most interest you receive is taxed as ordinary income, and therefore, subject to ordinary income tax rates. Notable exceptions include interest earned from a Series EE or Series I bond issued after 1989 that’s used to pay qualified higher educational expenses, interest on insurance dividends left on deposit with the U.S. Department of Veterans Affairs, and interest on some bonds used to finance government operations. However, even when it’s not taxable, interest still often needs to be reported.