What Is Ordinary Income, and How Is It Taxed?

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.

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.

Examples of Ordinary Income

Let’s take a look at how ordinary income works for individuals and businesses in the following examples.

Individuals

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.

Businesses

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.

Special Considerations

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.