What Is Ordinary Income?
Ordinary income refers to earnings that are subject to regular federal income tax rates. This fundamental concept within Taxation encompasses most types of income an individual or business receives, distinguishing them from other forms of income, such as capital gains, which may be taxed at different rates. The Internal Revenue Service (IRS) broadly defines income as money, property, or services received, and unless specifically exempted by law, it is generally considered taxable gross income. Wages, salaries, interest income from savings accounts or bonds, dividends (unless qualified), rental income, and business income are common examples of ordinary income.
History and Origin
The concept of taxing income has a long history in the United States, though the modern federal income tax as we know it is a relatively recent development. The U.S. first imposed a federal income tax in 1861 to help finance the Civil War, but this was a temporary measure repealed in 1872. A new income tax was enacted in 1894 but was quickly ruled unconstitutional by the Supreme Court.7
The modern federal income tax became a permanent fixture after the ratification of the Sixteenth Amendment to the U.S. Constitution in 1913. This amendment granted Congress the power "to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."6, Following its ratification, the Revenue Act of 1913 was passed, levying a progressive tax on personal incomes. The Internal Revenue Code (IRC), particularly Section 61, broadly defines what constitutes "gross income," which forms the basis for ordinary income and other income types.5 This statutory framework, overseen by the IRS, has evolved significantly over time, with ongoing adjustments to tax brackets and rates.4
Key Takeaways
- Ordinary income is broadly defined as any income subject to regular federal income tax rates.
- Common sources include wages, salaries, tips, commissions, business profits, interest, non-qualified dividends, and rental income.
- The taxation of ordinary income is progressive, meaning higher income levels are typically subject to higher marginal tax rates.
- Understanding ordinary income is crucial for accurate tax filing and effective financial planning.
- The IRS provides extensive guidance, such as Publication 525, to help taxpayers classify various income types.3
Interpreting Ordinary Income
Understanding ordinary income is fundamental for both individuals and businesses because it determines the majority of their taxable income. For individuals, income from employment, such as wages and bonuses, falls into this category. For businesses, ordinary income represents profits derived from their core operations, such as selling goods or services. The classification of income as "ordinary" dictates which tax rates apply. The U.S. tax system features progressive tax rates, meaning different portions of ordinary income are taxed at increasingly higher percentages as total income rises. Therefore, taxpayers evaluate their ordinary income to estimate their tax liability and plan accordingly.
Hypothetical Example
Consider Maria, a freelance graphic designer operating as a sole proprietorship. In a given year, Maria earns $75,000 from various client projects. This $75,000 represents her gross business income. She also earned $500 in interest from her savings account and received $200 in non-qualified dividends from a stock she briefly held.
From her business income, Maria can subtract eligible business deductions, such as expenses for software subscriptions, home office costs, and professional development. Let's assume her total business deductions amount to $15,000. Her net business income would be $75,000 - $15,000 = $60,000.
Maria's total ordinary income for the year would include her net business income ($60,000), her interest income ($500), and her non-qualified dividends ($200). Therefore, her total ordinary income for tax purposes, before considering personal deductions or standard deductions, is $60,000 + $500 + $200 = $60,700. This amount would then be subject to her applicable marginal tax rates.
Practical Applications
Ordinary income is central to various aspects of personal and corporate finance:
- Tax Filing and Compliance: Accurately reporting ordinary income is a primary requirement for tax compliance. The IRS provides detailed guidance through publications like Publication 525, which discusses different types of income and whether they are taxable or nontaxable.2
- Budgeting and Financial Planning: Understanding how much of one's income is considered ordinary income allows individuals and businesses to forecast their tax liabilities, which is critical for effective budgeting and financial planning.
- Investment Decisions: The tax treatment of different income types influences investment strategies. For example, investors often consider whether an investment generates ordinary income (like most bond interest or non-qualified dividends) or capital gains (from selling appreciated assets) due to potential differences in tax rates.
- Economic Policy: Governments utilize the taxation of ordinary income as a key tool for economic policy. Changes in income tax rates or the definition of ordinary income can influence consumer spending, savings, and investment behaviors. The broader implications of income tax policy are often analyzed by economic think tanks.,1
Limitations and Criticisms
While necessary for government funding, the taxation of ordinary income, particularly under a progressive system, can face criticisms. One common critique revolves around the complexity of the tax code, which can make it challenging for individuals and small businesses to accurately determine their taxable income without professional help. Furthermore, the varying tax treatments for different income types—such as the distinction between ordinary income and capital gains—can be seen as creating incentives that might favor certain economic activities or income sources over others.
Another point of discussion centers on the potential for higher marginal tax rates on ordinary income to disincentivize work or investment, although this is a subject of ongoing economic debate. The structure of tax brackets and the availability of deductions and tax credits continually evolve, adding layers of complexity that can make the system difficult to navigate for the average taxpayer. Discussions about tax reform often involve simplifying the categorization and taxation of various income streams, including ordinary income. The broader impact of income tax policy is a frequent subject of analysis by economic policy organizations.
Ordinary Income vs. Capital Gains
The primary distinction between ordinary income and capital gains lies in how they are generated and subsequently taxed. Ordinary income is generally derived from ongoing economic activities, such as earning wages, salaries, commissions, royalties, or profits from a trade or business. It also includes interest income and non-qualified dividends. This income is typically taxed at the standard progressive marginal tax rates applicable to a taxpayer's income level.
In contrast, capital gains result from the sale of a capital asset (such as stocks, bonds, or real estate) for a profit. For tax purposes, capital gains are further categorized as either short-term or long-term, depending on how long the asset was held before sale. Short-term capital gains, from assets held for one year or less, are taxed at the same rates as ordinary income. However, long-term capital gains, from assets held for more than one year, typically receive preferential tax treatment, meaning they are taxed at lower rates than ordinary income for most taxpayers. This difference in tax rates is a significant consideration in investment and financial planning.
FAQs
What are common examples of ordinary income?
Common examples of ordinary income include wages, salaries, tips, commissions, bonuses, profits from a business, rental income, interest income from bank accounts or bonds, and non-qualified dividends. Most forms of earned and unearned income are classified as ordinary income unless specifically designated otherwise by tax law.
How does ordinary income affect my taxes?
Your total ordinary income is a major component in determining your total gross income and, subsequently, your taxable income. This amount is then subject to federal income tax rates, which are progressive, meaning higher portions of income are taxed at higher rates. The more ordinary income you have, the higher your overall tax liability is likely to be, depending on available deductions and tax credits.
Is ordinary income the same as gross income?
No, ordinary income is a component of gross income, but they are not identical. Gross income is a broader term that includes all income from whatever source derived, unless specifically excluded by law. This can encompass ordinary income, as well as other types like qualified dividends, long-term capital gains, and certain tax-exempt income, before any deductions are applied. Ordinary income specifically refers to the portion of gross income taxed at regular income tax rates.
Are Social Security benefits considered ordinary income?
A portion of Social Security benefits may be considered ordinary income, depending on your total adjusted gross income and other factors. The IRS has specific rules to determine how much, if any, of your Social Security benefits are taxable.
Why is the distinction between ordinary income and other income types important?
The distinction is crucial because different types of income may be subject to different tax rates. For example, long-term capital gains and qualified dividends typically have lower tax rates than ordinary income, which can significantly impact an investor's after-tax returns. Understanding these distinctions is key for effective tax planning and optimizing financial outcomes.