 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.