Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Ordinary Income

What it is:

Ordinary income is not a capital gain, dividend or other income subject to special taxation.
 

How it works (Example):

In the United States, ordinary income is taxed progressively, meaning that there are a series of brackets in which income is taxed. For example, in 2006, the first $7,550 of ordinary income reported by a single person was taxed at 10%; then the income over $7,550 but below $30,650 was taxed at 15%. The income over $30,650 but below $74,200 was taxed at 25%; the income over $74,200 but below $154,800 was taxed at 28%; and the income over $154,800 but below $336,550 was taxed at 33%. Any income over $336,550 was taxed at 35%.

For example, assume you are a single filer who earned $200,000 in 2006 from Company XYZ. The ordinary income on this amount is as follows:

  • $755.00 (tax on the first $7,550 of income, taxed at the 10% rate), plus
  • $3,465.00 (tax on the income between $7,550 and $30,650, taxed at 15%), plus
  • $10,887.50 (tax on the income between $30,650 and $74,200, taxed at 25%), plus
  • $22,568.00 (tax on the income between $74,200 and $154,800, taxed at 28%), plus
  • $14,916.00 (tax on the income between $154,800 and $336,550, taxed at 33%), for a total of $52,591.50

In this example, every extra dollar you earn is taxed at 33%, but your average tax rate is $52,591.50 / $200,000 = 26.3%

Why it Matters:

Wages are the most common items taxed as ordinary income. Capital gains are taxed at different rates, as are dividends (15%). Interest earned is sometimes exempt from ordinary income taxes (as in the case of most municipal bond investments).

Knowing how taxes affect one's portfolio can make a big difference in investing decisions. For example, one big advantage to owning dividend stocks is their generally favorable tax treatment. Until 2003, dividends were taxed as ordinary income -- up to 38.6% -- and capital gains were taxed at a much lower 20%. In 2003, the tax on most dividend income and some capital gains fell to 15%. Not only did this encourage companies to increase dividends, it encouraged stock ownership because interest income from Treasuries and money market funds was still taxed as ordinary income.