The Internal Revenue Service classifies the money you make in one of two categories: ordinary income and capital gains. Different tax rates apply to each kind of income. Most, and often all, of the income that most taxpayers report on their tax returns is ordinary income.
Definition of Ordinary Income
It may be simpler to define ordinary income by what it isn't than by what it is: Ordinary income is money you receive that doesn't qualify as a capital gain. Capital gains are profits from the sale of "capital assets" such as stocks, bonds, real estate, artwork, vehicles, collectibles and anything else bought for either investment purposes or for personal use. Simply put, if you sell something for more money than you paid to acquire it, or for more than it was worth when you obtained it, as with an inherited item, your profit is a capital gain. Since the tax code aims to reward long-term investment, capital gains are generally taxed at lower rates than ordinary income.
Examples of Ordinary Income
Ordinary income is "everything else" on your tax return. For most people, the biggest chunk of ordinary income comes from their job: wages, tips, bonuses and commissions. Profit from an ownership interest in a sole proprietorship, partnership, limited liability company or Subchapter S corporation also counts as ordinary income. Other common sources include interest income; alimony; gambling winnings; taxable distributions from retirement accounts, pensions and annuities; and income from rents, royalties and trusts.
How the IRS Handles Dividends
Dividends – distributions of corporate profit to shareholders – may be taxed either as ordinary income or as capital gains, depending on the nature of the dividend. According to the Internal Revenue Service, most dividends are "ordinary dividends" and are treated as ordinary income. "Qualified dividends," on the other hand, are treated like capital gains. To count as qualified, a dividend must meet specific criteria set by the government. The IRS advises that you assume that a dividend is ordinary unless you're told otherwise by the company or mutual fund paying the dividend.
Tax Rates for Ordinary Income
As of 2018, the federal government taxes ordinary income, minus deductions, at seven different rates. Those rates: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent. Each rate applies to a different portion of taxable ordinary income. For example, a single taxpayer with taxable ordinary income of $50,000 would pay 10 percent on taxable income up to $9,525, then 12 percent on taxable income from $9525 to $38,700, and then 24 percent on income from $38,700 to $50,000. Your "tax bracket" is the highest rate that applies to your ordinary income.