Ordinary Income: Definition & How It Is Taxed?

KEY TAKEAWAYS

• Ordinary income is any money that is earned or received from employment or business activities. It gets taxed based on the tax rates outlined by the IRS.
• Some of the most common forms of ordinary income include hourly wages, yearly salaries, bonuses, commissions, tips, and royalties.
• Individuals earn ordinary income from wages or self-employment.
• For corporations, ordinary income relates to the revenue earned from day-to-day business operations. This doesn’t include income earned from the sale of a capital asset.

What Is An Ordinary Income?

For tax purposes, all income is treated as ordinary income, unless it is defined as something else (for example, capital gains income). Ordinary income is also referred to as earned income. It’s any money that’s earned or received from your employer or through business activities. Ordinary income earnings are subject to various tax rates outlined by the Internal Revenue Service (IRS), such as income tax, marginal income tax, and ordinary tax. 

Some of the more common forms of ordinary income include an annual salary, hourly wages, bonuses, or earned commissions. If you’re a sole proprietor and operate your own business, ordinary income is the same as self-employment earnings, This includes any additional earnings, like bonuses, which are subject to the applicable bonus tax rate, determined by the IRS.

Individuals and businesses get taxed differently depending on the specific type of earnings. Any earnings can get classified or categorized as ordinary or unearned income. Unearned income, which is also referred to as passive income, includes income earned from investments, such as ordinary dividends, taxable interest, or capital gain distributions.

How Is Ordinary Income Calculated?

Ordinary income is calculated by adding the relevant and necessary income streams for an individual or business. On top of wages and salaries, there can be different forms of income, including the following: 

• Short-term capital gains
• Interest earned from bonds 
• Royalties
• Employee stock options
• Annuity and retirement plan distributions 
• Rental property income 
• Ordinary or unqualified dividend income
• Interest income

Anything that can be classified as a long-term capital gain is excluded from ordinary income, such as various long-term investment income.

What Is Taxed As Ordinary Income?

The IRS determines the federal tax rates you must pay based on your annual earnings. This is called a marginal tax rate and it increases as the level of income rises. Most income is  taxed at the marginal tax rate and it can provide more favorable tax treatment. 

However, there are a few exceptions worth highlighting. Certain qualified dividends and long-term capital gains can be subject to more favorable tax rates. There are certain eligibility requirements but this can help reduce your tax liability.

Earned Income vs. Unearned Income

There are some major differences between earned  and unearned income, including how they’re taxed and earned. The simplest way to understand earned income is that it is actively earned. For example, you receive an hourly wage or a salary at your job in return for the work you perform. This income gets taxed at marginal tax rates which can often be higher compared to unearned income. 

Unearned income, on the other hand, is passive income. This could be an asset that was purchased and has continued to appreciate in value, or investment income. Unearned income gets taxed at more favorable rates and can range from 0 percent to 20 percent.

Example of Ordinary Income

Ordinary income is fairly straightforward to understand, although it can differ a little bit between an individual and a business. Let’s take a closer look at an example of ordinary income for an individual. 

Ordinary income will typically include hourly wages or a salary that’s earned from the employer. Let’s say that Jennifer works at Walmart and earns $2,500 per month. To find her annual ordinary income, she would multiply her monthly earnings by 12. 

2,500 x 12 = 30,000

Jennifer doesn’t have any other taxable income sources. In this case, she would get taxed on her $30,000 on her federal tax return. However, if Jennifer had income from a rental property, it would get added to her yearly earnings, increasing her ordinary income.

Summary

Ordinary income is any type of income that’s earned by a business or individual and is subject to ordinary tax rates. Some of the most common types of ordinary income include yearly salaries, hourly wages, bonuses, commissions, and interest income. 

Different levels of income get taxed at varying rates and it can depend on the type of earnings. There can be preferential rates compared to ordinary rates based on the type of a single taxpayer income. These earnings can then get categorized as either unearned or earned income. 

For businesses and corporations, ordinary income is generated through day-to-day business operations. It gets taxed based on federal income tax rates and individual tax brackets.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.