Ordinary income is any type of earnings that get taxed at regular income tax rates as opposed to other types of rates, such as long-term capital gains tax rates.
Keep reading to learn what ordinary income is and how it can help you improve your tax planning.
Definition and Examples of Ordinary Income
Ordinary income can be any type of income that counts as taxable income and is taxed at ordinary income tax rates. The more ordinary income you earn, the higher the tax rate on those earnings.
Examples of ordinary income include wages from an employer or interest from a bank account. However, ordinary income is more than just what you receive regularly from a paycheck. Many other types of earnings can count as ordinary income, ranging from royalties to certain types of court awards and damages.
Some types of court awards and damages could be characterized as capital gains, so it’s important to know what applies to your specific situation.
How Ordinary Income Works
Ordinary income occurs when you receive wages or other types of earnings that get taxed at regular income tax rates. For tax year 2022, federal tax rates for ordinary income start at 10% for taxable income up to $10,275 for single filers ($20,550 for married couples filing jointly), and they get progressively higher up to the 37% rate for income above $539,900 for single filers ($647,850 for married couples filing jointly).
Capital gains and other types of income can come with much lower rates, depending on your income. If you sell stocks or bonds for a profit, for example, you may be eligible for considerable savings compared to ordinary income tax rates if you held the investment for more than a year.
Because of the difference between capital gains rates and ordinary income rates, it’s often beneficial for individuals to avoid characterizing income as ordinary income whenever possible. For example, if you’re thinking about selling stock that you’ve only held for a few months, you may want to consider whether it’s worth it to hold onto the asset for longer. If you can hold it for at least a year and a day, then the profit won’t count as ordinary income, and you can eventually treat it as a long-term capital gain at a better tax rate.
Alternatives to Ordinary Income
One of the most common alternatives to ordinary income is long-term capital gains income. Long-term capital gains occur when an investor sells an investment for a profit after holding it for more than a year. Instead of getting taxed at the ordinary income rate, those earnings get taxed at a separate long-term capital gains rate. These rates tend to be lower than ordinary income tax rates.
Many taxpayers pay 15% on their long-term capital gains. Compare that to the 22% an individual would pay on ordinary income of $41,776 to $89,075 for the 2022 tax year.
Ordinary income also differs from supplemental income. If you receive other types of pay other than hourly wages or a salary, such as bonuses or commissions, those would generally count as supplemental income, and it may be taxed at 22% regardless of your marginal tax rate.
What Ordinary Income Means for Individuals
Understanding ordinary income can help individuals when it comes to filing taxes, as well as potentially providing an advantage when it comes to tax planning. You might overlook earnings such as bank interest, for example, but it’s important to know that you need to pay ordinary income taxes on these amounts.
If you have substantial interest or other types of ordinary income that affect your tax rates, that could be something to keep in mind if you’re working on tax-reduction strategies (like deciding when to make a tax-deductible purchase).
Understanding ordinary income can also help when it comes to areas such as employee stock options. Some types of stock options can be taxed at favorable capital gains rates, but you might have to treat gains from these options as ordinary income if you don’t meet certain requirements, such as a holding period requirement.
It can be useful to understand different types of income and tax rates and figure out ways to treat earnings as something other than ordinary income.
- Ordinary income applies to earnings subject to regular income tax rates.
- Ordinary income tax rates are often higher than other types, such as long-term capital gains rates.
- Understanding what counts as ordinary income can help individuals improve tax planning.