What it is:
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 (as in the case of most municipal bond ).
Knowing how affect one's portfolio can make a big difference in investing decisions. For example, one big advantage to owning 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 income and some capital gains fell to 15%. Not only did this encourage companies to increase , it encouraged stock ownership because interest income from Treasuries and money funds was still taxed as ordinary income.