Young businessman presenting a perfect ecology land with a house and windmills

 

What Is Ordinary Income?

Ordinary income is income that is taxed as ordinary income tax rates and does not qualify for capital gains tax treatment. It's important to understand the difference between ordinary income and capital gain income because, generally, ordinary income tax rates are higher than capital gains tax rates.

It may be easier to understand what ordinary income is by understanding what it is not — it is not capital gain income from the sale or exchange of assets, or income from the sale of certain property used in a trade or business (Section 1231 property). Ordinary income can be derived from:

  • Wages, salaries, tips, and other employment compensation
  • Interest earned on savings and investments
  • Alimony
  • Business and farm income
  • Taxable portions of distributions from IRAs, retirement plans, and annuities
  • Rents and royalties
  • Unemployment compensation
  • Taxable portions of Social Security payments
  • Gambling winnings

In order to understand how ordinary income affects your tax liability, you should know what ordinary income is, how it is taxed, when it is preferable to capital gain income, and how to accelerate or defer the recognition of ordinary income.

Tip: Qualifying dividends paid to individual shareholders are taxed at long-term capital gains tax rates.

Taxation of Ordinary Income

Generally speaking (and with limitations), ordinary income is reduced by ordinary losses and deductions. The balance is taxed at ordinary income tax rates. Ordinary income rates tend to be less favorable than long-term capital gains tax rates. As a result, investors generally prefer long-term capital gains to ordinary income. However, there are times when ordinary income may produce a more favorable tax result.

Ordinary Income May Be Preferable on Occasion

Ordinary income is preferable if you have ordinary losses or deductions items that can be used to reduce your taxable income. Your personal situation may also dictate a need for ordinary income earnings.

Accelerating or Deferring Ordinary Income

The main strategies to accelerate or defer ordinary income focus on the timing of investment purchases and sales. (Retirement strategies also provide opportunities to defer or generate ordinary income.)

How Is Ordinary Income Taxed?

Ordinary income is taxed as ordinary income tax rates. These rates depend on your filing status and the amount of your taxable income.

Ordinary Tax Rates and Filing Status

In order to ascertain the tax rate applicable to your ordinary income, you must first know your filing status. The tax rate schedules for 2020 are as follows:

Single:

If Taxable Income Is:

Your Tax Is:

Not over $9,875

10% of taxable income

Over $9,875 to $40,125

$987.50 + 12% of the excess over $9,875

Over $40,125 to $85,525

$4,617.50 + 22% of the excess over $40,125

Over $85,525 to $163,300

$14,605.50 + 24% of the excess over $85,525

Over $163,300 to $207,350

$33,271.50 + 32% of the excess over $163,300

Over $207,350 to $518,400

$47,367.50 + 35% of the excess over $207,350

Over $518,400

$156,235 + 37% of the excess over $518,400

Married Filing Jointly and Surviving Spouses:

If Taxable Income Is:

Your Tax Is:

Not over $19,750

10% of taxable income

Over $19,750 to $80,250

$1,975 + 12% of the excess over $19,750

Over $80,250 to $171,050

$9,235 + 22% of the excess over $80,250

Over $171,050 to $326,600

$29,211 + 24% of the excess over $171,050

Over $326,600 to $414,700

$66,543 + 32% of the excess over $326,600

Over $414,700 to $622,050

$94,735 + 35% of the excess over $414,700

Over $622,050

$167,307.50 + 37.6% of the excess over $622,050

Married Individuals Filing Separately:

If Taxable Income Is:

Your Tax Is:

Not over $9,875

10% of taxable income

Over $9,875 to $40,125

$987.50 + 12% of the excess over $9,875

Over $40,125 to $85,525

$4,617.50 + 22% of the excess over $40,125

Over $85,525 to $163,300

$14,605.50 + 24% of the excess over $85,525

Over $163,300 to $207,350

$33,271.50 + 32% of the excess over $163,300

Over $207,350 to $311,025

$47,367.50 + 35% of the excess over $207,350

Over $311,025

$83,653.75 + 37% of the excess over $311,025

Heads of Household:

If Taxable Income Is:

Your Tax Is:

Not over $14,100

10% of taxable income

Over $14,100 to $53,700

$1,410 + 12% of the excess over $14,100

Over $53,700 to $85,500

$6,162 + 22% of the excess over $53,700

Over $85,500 to $163,300

$13,158 + 24% of the excess over $85,500

Over $163,300 to $207,350

$31,830 + 32% of the excess over $163,300

Over $207,350 to $518,400

$45,926 + 35% of the excess over $207,350

Over $518,400

$154,793 + 37% of the excess over $518,400

Trusts and Estates:

If Taxable Income Is:

Your Tax Is:

Not over $2,600

10% of taxable income

Over $2,600 to $9,450

$1,410 + 12% of the excess over $14,100

Over $9,450 to $12,950

$6,162 + 22% of the excess over $53,700

Over $12,950

$13,158 + 24% of the excess over $85,500

The tax rate schedules for 2019 are as follows:

Retirekit CTA

Single:

If Taxable Income Is:

Your Tax Is:

Not over $9,700

10% of taxable income

Over $9,700 to $39,475

$970 + 12% of the excess over $9,700

Over $39,475 to $84,200

$4,543 + 22% of the excess over $39,475

Over $84,200 to $160,725

$14,382.50 + 24% of the excess over $84,200

Over $160,725 to $204,100

$32,748.50 + 32% of the excess over $160,725

Over $204,100 to $510,300

$46,628.50 + 35% of the excess over $204,100

Over $510,300

$155,798.50 + 37% of the excess over $510,300

Married Filing Jointly and Surviving Spouses:

If Taxable Income Is:

Your Tax Is:

Not over $19,400

10% of taxable income

Over $19,400 to $78,950

$1,940 + 12% of the excess over $19,400

Over $78,950 to $168,400

$9,086 + 22% of the excess over $78,950

Over $168,400 to $321,450

$28,765 + 24% of the excess over $168,400

Over $321,450 to $408,200

$65,497 + 32% of the excess over $321,450

Over $408,200 to $612,350

$93,257 + 35% of the excess over $408,200

Over $612,350

$164,709.50 + 37.6% of the excess over $612,350

Married Individuals Filing Separately:

If Taxable Income Is:

Your Tax Is:

Not over $9,700

10% of taxable income

Over $9,700 to $39,475

$970 + 12% of the excess over $9,700

Over $39,475 to $84,200

$4,543 + 22% of the excess over $39,475

Over $84,200 to $160,725

$14,382.50 + 24% of the excess over $84,200

Over $160,725 to $204,100

$32,748.50 + 32% of the excess over $160,725

Over $204,100 to $306,175

$46,628.50 + 35% of the excess over $204,100

Over $306,175

$82,354.75 + 37% of the excess over $306,175

Heads of Household:

If Taxable Income Is:

Your Tax Is:

Not over $13,850

10% of taxable income

Over $13,850 to $52,850

$1,385 + 12% of the excess over $13,850

Over $52,850 to $84,200

$6,065 + 22% of the excess over $52,850

Over $84,200 to $160,700

$12,962 + 24% of the excess over $84,200

Over $160,700 to $204,100

$31,322 + 32% of the excess over $160,700

Over $204,100 to $510,300

$45,210 + 35% of the excess over $204,100

Over $510,300

$152,380 + 37% of the excess over $510,300

Trusts and Estates:

If Taxable Income Is:

Your Tax Is:

Not over $2,600

10% of taxable income

Over $2,600 to $9,300

$260 + 24% of the excess over $2,600

Over $9,300 to $12,750

$1,868 + 35% of the excess over $9,300

Over $12,750

$3,075.50 + 37% of the excess over $12,750

Marginal Tax Rates

A tax bracket expresses the income tax rate for a given range of income. Ordinary income tax rates are progressive. In other words, the tax rate increases on successively greater earnings. Tax brackets measure this progressive tax structure. The marginal tax rate expresses your rate of tax on your next dollar of income. Currently, the top marginal tax rate for ordinary income is 37 percent. Your effective rate of tax may be greater or less than your marginal rate, depending on the availability of certain losses and deductions. In any event, the marginal rate can provide a quick measure of the tax cost of your investment earnings.

Effective Tax Rates

The effective tax rate measures your actual tax liability as a percentage of your taxable income. In other words, this measures what you actually pay in taxes after considering disallowed deductions or losses. When your taxable income exceeds your true economic income, the effective tax rate is greater than your marginal tax rate. This provides the best measure of the tax cost of your investment earnings.

When Is Ordinary Income Preferable?

Ordinary income may be preferable for both tax and nontax reasons.

Ordinary Income May Be Preferable For Nontax Reasons

You may need a stream of income from investments to live on or to supplement your earnings from other sources. You may feel that selling an income-producing investment may not be wise (from an investment standpoint). By pursuing a particular investment strategy that emphasizes diversification or minimizes risk, you may want to include bonds and money market mutual funds in your portfolio, which pay interest. So, your personal needs and your investment strategy — not taxes — may dictate your investment holdings and may consequently dictate the character of your income for federal income tax purposes.

Ordinary Income May Be Preferable For Tax Reasons

Although capital gains tax rates are much more favorable than ordinary income tax rates, there are three instances when you might prefer ordinary income:

  • When you have unused ordinary losses or deductions: Allowable deductions and losses reduce your taxable income.

Example(s): Say you have $100 of income this year and also have $100 of student loan interest. You have no other deductions, so your gross income equals $100. Your adjusted gross income (AGI), however, is $0. This is what is meant when it is stated that ordinary losses and deductions reduce or offset your taxable income. If you did not have the student loan interest deduction, your AGI would equal $100. AGI is the base from which you determine your taxable income.

But what if you have more deductions than income?

Example(s): Assume you have $100 of income this year and $200 of student loan interest. You have no other deductions, so your gross income would equal $100 and your AGI would be $0. However, you would have an unused $100 loss. Now assume that you also bought bonds that produced $100 in interest. You can use your loss to offset the interest income from the bonds. Thus, your current AGI would be $0 despite the interest payment. In this case, you have accelerated your income in order to take advantage of an existing loss.

With one limited exception, you generally must match your ordinary deductions and losses to ordinary income.

  • When you have unused capital losses: As we just discussed, you generally must match your ordinary income to ordinary losses and deductions. The matching principle also applies to capital gain and loss. There is one exception, however. If you have a net capital loss and do not have any unused ordinary losses, you are permitted to reduce ordinary income by $3,000 ($1,500 if married filing separately) of your net capital loss. So, when you have net capital losses, you may want to consider accelerating the recognition of ordinary income to take advantage of the availability of this loss.
  • When the ordinary income is passive and you have passive losses: The passive-activity loss rules apply to your loss derived from investments in a passive activity. Generally speaking, a passive activity is any investment in a business in which you participate less than 500 hours per year. The passive-loss rule states that losses from your passive activity may be used only to reduce income from passive activities. Therefore, if you have passive losses, you may want to accelerate passive income.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

 

The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.

 


TRG Retirement Guide

Tags: Financial Planning, Lump Sum, Pension, Retirement Planning