Ordinary Income

Ordinary income from an employer can be hourly wages, annual salary, commissions or bonuses. If you work for yourself, your ordinary income would be your self-employment earnings.

The IRS taxes income differently based on the type of earnings individuals and businesses receive. Earnings can be categorized as either ordinary income (earned income) or unearned income (passive income).

Recognizing the difference between ordinary and unearned income is an important step in building your financial literacy.

Ordinary income can be personal or business-related.

Consider this: You have a job at your local bakery. You receive an hourly wage of $15, and some of your loyal customers leave money in the tip jar after each purchase. The bakery also pays you $2 commission on every birthday cake you sell.

These earnings are considered your ordinary income. You claim these payments as income in your annual tax return, and the money is subject to the marginal tax rate established by the IRS each year.

In addition to wages, salary, tips and commissions, other types of ordinary income that individuals can receive include:

The bakery’s pre-tax profits from selling its products are considered ordinary income for the business itself. Also, the owners of the bakery’s building earn ordinary income in this example, as they collect a monthly rent payment from the business.

Ordinary income and unearned income differ in how they are earned and taxed.

Ordinary income is actively earned, while unearned income is passive. In most cases, you earn ordinary income as a direct result of your labor. On the other hand, passive income can happen in the background — such as an asset appreciating in value.

The IRS taxes ordinary income at marginal rates, which are often higher than taxation on unearned income.

Unearned income is taxed with lower, preferential rates: from 0 percent to 20 percent. These reduced rates serve as an incentive for taxpayers saving for retirement.

Understanding the taxation on your earnings — whether ordinary income or capital gains — can help you optimize your returns over time, especially with long-term retirement and annuity products.

“The reason why it is important to understand the difference between capital gains and ordinary income is because gains from nonqualified annuity contracts — that is, annuity contracts outside of a retirement plan — are taxed at ordinary income rates, which are higher than capital gains rates,” Marguerita Cheng, CFP® professional and Retirement Income Certified Professional®, told Annuity.org.

Ordinary income is subject to the IRS-determined federal tax rates based on your annual earnings. This rate, called a marginal tax rate, raises with higher levels of income.