What Is Ordinary Income Tax and How Is It Calculated?

Ordinary income tax is the system used to tax most annual earnings. It is the default method for taxation unless the income qualifies for special treatment, and it uses a progressive structure where the tax rate rises with income. The calculation starts with total income, which is reduced by deductions to find a final taxable amount. This figure is used with specific rate schedules to compute the tax owed, and tax credits can be applied to lower the final bill.

Sources of Ordinary Income

The Internal Revenue Service (IRS) broadly defines ordinary income to include most earnings. This includes compensation from employment like wages, salaries, and bonuses, which are reported on a Form W-2. Net profit from self-employment or a sole proprietorship is also ordinary income.

Ordinary income also includes many types of unearned income, such as interest from bank accounts and bonds. Royalties and rental income from real estate activities also fall into this category. Most money received is treated as ordinary income unless specified otherwise by tax law.

Short-term capital gains are also ordinary income. When an asset like a stock is sold after being held for one year or less, the profit is a short-term capital gain taxed at regular rates. Dividends that are not “qualified” are also taxed as ordinary income.

It is also important to understand what is not ordinary income. Common exceptions are long-term capital gains and qualified dividends, which receive preferential tax treatment. A long-term capital gain occurs when an asset is sold for a profit after being held for more than one year and is taxed at lower rates of 0%, 15%, or 20% depending on income.

Qualified dividends are also taxed at the lower long-term capital gains rates. To be considered qualified, an investor must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. This preferential treatment for both is designed to encourage long-term investment.

Calculating Taxable Income

To determine taxable income, you first calculate gross income, which includes all ordinary income. From this total, you subtract “above-the-line” deductions, found on Schedule 1 of Form 1040, to find your Adjusted Gross Income (AGI).

Common above-the-line deductions include:

• Contributions to a traditional IRA, which for 2024 are up to $7,000 ($8,000 if age 50 or over) and may be deductible.
• Up to $2,500 in student loan interest paid on qualified loans.
• A portion of the self-employment tax paid.
• Educator expenses.
• Contributions to a Health Savings Account (HSA).

After calculating AGI, you subtract either the standard deduction or your total itemized deductions, choosing whichever is larger. The standard deduction is a fixed amount based on filing status, age, and blindness. For the 2024 tax year, the standard deduction is $14,600 for single individuals and $29,200 for married couples filing jointly.

Itemized deductions are specific expenses reported on Schedule A of Form 1040. Common deductions include:

• Mortgage interest on a primary residence.
• State and local taxes (SALT), up to a $10,000 limit per household.
• Charitable contributions.
• Medical and dental expenses that exceed 7.5% of your AGI.

You should itemize only if your total deductions exceed your standard deduction amount. For instance, a single individual with $16,000 in itemized deductions would choose that over the $14,600 standard deduction. The number remaining after this subtraction is your taxable income.

Determining Your Tax Liability

Your tax liability is determined by your filing status and the federal income tax brackets. Your filing status is based on your marital and family situation. The five statuses are:

• Single
• Married Filing Jointly
• Married Filing Separately
• Head of Household
• Qualifying Widow(er)

The U.S. uses a progressive tax system with seven federal income tax brackets for 2024: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. A common misconception is that all your income is taxed at your highest bracket’s rate. In reality, this marginal tax rate applies only to the income within that specific bracket.

For example, a single individual with $100,000 of taxable income in 2024 would not pay a flat 24%. Instead, the tax is calculated in pieces. The first $11,600 is taxed at 10% ($1,160). The income from $11,601 to $47,150 is taxed at 12% ($4,266).

The income from $47,151 up to their $100,000 total is taxed at 22% ($11,626.78). The total tax liability is the sum of these pieces: $1,160 + $4,266 + $11,626.78, for a total of $17,052.78. This method ensures that every taxpayer pays the same rate on the same income levels, regardless of their overall earnings.

Reducing Your Final Tax Bill with Credits

After calculating your tax liability, you can apply tax credits to lower what you owe. Tax credits are more beneficial than deductions because they provide a dollar-for-dollar reduction of your tax bill. For example, a $1,000 tax credit lowers your tax bill by $1,000.

Tax credits are either non-refundable or refundable. A non-refundable credit can reduce your tax liability to zero, but you do not get a refund for any excess amount. If you owe $800 in taxes and have a $1,000 non-refundable credit, your tax bill becomes zero, but you do not receive the remaining $200.

Common non-refundable credits include the credit for other dependents, the American Opportunity Tax Credit, and the credit for child and dependent care expenses.

Refundable credits are paid out in full, even if the credit exceeds your tax liability. If you owe $500 in taxes and have a $1,500 refundable credit, your tax bill is eliminated, and you receive the remaining $1,000 as a tax refund.

Prominent refundable credits include the Earned Income Tax Credit (EITC) and the Child Tax Credit. The EITC is a benefit for working people with low to moderate income. The Child Tax Credit provides a credit for each qualifying child, and for 2024, up to $1,700 of it is refundable for many families.