2. Wages, Interest, Dividends, and Ordinary Income

How the ordinary income tax brackets work

Before getting into the individual income types, it is worth being precise about how the bracket system actually operates, because the most common misunderstanding in individual tax is also the most consequential one.

The US federal income tax uses a progressive marginal rate structure. The rates for 2025 apply to taxable income, which is gross income minus adjustments, minus either the standard deduction or itemized deductions. The brackets for 2025 are as follows.

For single filers: 10% on the first $11,925 of taxable income; 12% from $11,925 to $48,475; 22% from $48,475 to $103,350; 24% from $103,350 to $197,300; 32% from $197,300 to $250,525; 35% from $250,525 to $626,350; and 37% on income above $626,350.

For married filing jointly: 10% on the first $23,850; 12% from $23,850 to $96,950; 22% from $96,950 to $206,700; 24% from $206,700 to $394,600; 32% from $394,600 to $501,050; 35% from $501,050 to $751,600; and 37% above $751,600.

The critical point is that each rate applies only to the income within that bracket, not to all income. A single filer with $120,000 of taxable income does not pay 24% on the whole amount. She pays 10% on the first $11,925, 12% on the next $36,550, 22% on the next $54,875, and 24% only on the remaining $18,650. Her effective rate, meaning total tax divided by total taxable income, is considerably lower than 24%.

Example: Daniel is a single filer with $150,000 in taxable income. His federal income tax for 2025 is calculated as follows: $1,192.50 on the first $11,925, plus $4,386 on the next $36,550, plus $12,072.50 on the next $54,875, plus $11,352 on the remaining $47,700 in the 24% bracket. Total federal income tax: approximately $29,003. His effective rate is 19.3%, not 24%.

This distinction between marginal rate and effective rate matters for planning. When someone says they are in the 24% bracket, they mean that additional income above the threshold will be taxed at 24%, not that their overall burden is 24%.

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## Wages and salary

Wages, salaries, tips, and other compensation for services are the most straightforward form of ordinary income. They are reported by employers on Form W-2 and flow directly to Form 1040 as gross income.

What appears in Box 1 of the W-2, labeled "Wages, tips, other compensation," is not the same as total compensation paid. Certain pre-tax deductions reduce Box 1. Contributions to a 401(k) or 403(b) made through a salary deferral reduce taxable wages. Employer-sponsored health insurance premiums paid through a Section 125 cafeteria plan reduce taxable wages. Health Savings Account contributions made through payroll also reduce Box 1. The result is that a person earning $90,000 in gross salary may have considerably less than that reported as taxable wages after pre-tax benefit deductions.

This is worth understanding because it explains why payroll tax and income tax treat the same compensation differently. Social Security and Medicare taxes are calculated on a different wage base than income tax, and some pre-tax deductions that reduce income tax wages do not reduce payroll tax wages.

### Fringe benefits: what is excluded and what is not

The Internal Revenue Code contains a long list of employer-provided benefits that are excluded from an employee's taxable wages. Understanding which benefits are excluded, and under what conditions, is relevant both for employees reviewing their own compensation and for founders structuring benefit packages for their businesses.

Group term life insurance provided by an employer is excluded from income up to $50,000 of coverage. Coverage above $50,000 generates imputed income calculated using IRS tables, and that imputed amount is included in Box 1 of the W-2.

Employer-paid health and accident insurance premiums are fully excluded from gross income. This is one of the most valuable tax preferences available to employees and is not available to the self-employed in the same form, though the self-employed health insurance deduction partially compensates for this, as discussed in Part 3.

Dependent care assistance provided through a Section 129 plan is excluded up to $5,000 per year ($2,500 for married filing separately). This is distinct from the dependent care credit discussed in Part 8, and the two interact: amounts excluded through an employer plan reduce the expenses eligible for the credit.

Educational assistance up to $5,250 per year under a Section 127 plan is excluded from wages. This covers tuition, fees, books, and similar expenses paid by the employer under a qualifying program. Amounts above $5,250, or amounts paid outside a qualifying plan, are taxable.

Commuter benefits for transit passes and vanpooling are excluded up to $325 per month in 2025. Qualified parking is excluded up to the same limit. These numbers are adjusted for inflation annually and are worth knowing because they reduce taxable wages with no administrative burden beyond enrollment in the employer's plan.

Meals and lodging provided for the convenience of the employer and on the employer's business premises are excluded entirely. This is a fact-specific determination, but for employees at certain types of businesses, such as hotel workers or resident managers, it can represent meaningful tax-free compensation.

### Equity compensation: RSUs, NSOs, and ISOs

For founders, early employees, and executives, equity compensation is often a significant portion of total economic compensation, and its tax treatment is one of the more complex areas of individual income tax.

Restricted stock units, or RSUs, are the simplest form of equity compensation from a tax perspective. When RSUs vest, the fair market value of the shares at the vesting date is ordinary income, reported on the W-2 as wages. The employer typically withholds tax at the supplemental wage rate of 22% (37% above $1 million), which may or may not match the employee's actual marginal rate. Any subsequent gain or loss from the sale of the shares after vesting is capital gain or loss, covered in Part 4.

Example: Sophie receives 500 RSUs that vest when the company's stock is trading at $40. She has $20,000 of ordinary income at vesting, reported as wages on her W-2. If she holds the shares and sells six months later at $50, the additional $10,000 is a short-term capital gain taxed at ordinary income rates. If she waits until the shares have been held for more than a year from the vest date and sells at $50, the additional $10,000 is a long-term capital gain taxed at preferential rates.

Non-qualified stock options, or NSOs, are taxed on exercise. When an employee exercises an NSO, the spread between the exercise price and the fair market value at exercise is ordinary income, again reported as wages on the W-2. The decision of when to exercise therefore has direct income tax consequences: exercising when the stock price is high means more ordinary income recognized immediately.

Incentive stock options, or ISOs, receive more favorable treatment under the regular tax system. There is no ordinary income recognized at exercise. Instead, the spread at exercise is an adjustment for alternative minimum tax purposes. If the employee holds the shares for at least two years from the grant date and one year from the exercise date, any gain on sale is long-term capital gain. If the shares are sold before satisfying these holding periods in what is called a disqualifying disposition, the gain is treated as ordinary income similar to an NSO. ISO planning involves balancing the AMT risk at exercise against the benefit of long-term capital gain treatment at sale.

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## Interest income

Interest income is ordinary income. It is reported on Form 1099-INT by the institution paying it and flows to Schedule B on the return. The principal categories of interest income and their treatment are worth knowing in detail.

### Taxable interest

Bank deposit interest, savings account interest, interest on certificates of deposit, and interest on corporate bonds are all fully taxable at ordinary income rates. Interest on US Treasury bonds, notes, and bills is also fully taxable at the federal level, though it is exempt from state and local income tax. This exemption from state tax is meaningful in high-tax states and is one reason Treasury securities are preferred over corporate bonds for some investors in states like California or New York.

Series EE and Series I US savings bonds receive deferred treatment. Interest on these bonds is not taxable until the bond is redeemed or reaches final maturity, whichever comes first. There is an option to report the interest annually as it accrues, which can be useful in low-income years, but most holders defer it. When the bond is finally redeemed, the full accumulated interest is ordinary income in that year. For education planning purposes, there is an exclusion available when savings bond proceeds are used for qualified higher education expenses, subject to income phaseout rules.

Original issue discount, known as OID, is a category that surprises many taxpayers. When a bond is issued at a price below its face value, the difference is OID. The holder must recognize a portion of the OID as interest income each year over the life of the bond, even if no cash is actually received. The amount to recognize each year is calculated using the bond's yield to maturity and the holder's adjusted basis. Brokers report this on Form 1099-OID.

### Tax-exempt interest: municipal bonds

Interest on bonds issued by state and local governments is generally exempt from federal income tax. This is the defining feature of the municipal bond market and the reason that municipalities can borrow at lower rates than comparable taxable issuers: investors accept a lower nominal yield because the after-tax return is competitive.

The exemption applies at the federal level. Whether municipal bond interest is also exempt from state and local tax depends on the state and on whether the bond was issued within or outside that state. Most states exempt interest on their own bonds but tax interest from out-of-state munis. For investors in high-tax states holding a diversified muni fund, a portion of the fund's interest income may therefore be state-taxable even though it is all federally exempt.

One important exception involves private activity bonds. Certain municipal bonds finance private activities such as airports, student loans, or housing, and interest on these bonds, while still federally exempt from regular income tax, is a preference item for alternative minimum tax purposes. For taxpayers subject to AMT, private activity bond interest effectively loses its exemption.

To compare a tax-exempt yield to a taxable yield, the taxable equivalent yield calculation divides the tax-exempt rate by one minus the marginal rate. For a taxpayer in the 32% bracket, a municipal bond yielding 3.5% is equivalent to a taxable bond yielding 3.5% divided by 0.68, which is approximately 5.15%. This calculation is a useful tool for evaluating municipal bond investments and is tested on the EA exam.

Example: Lin is in the 24% federal bracket and her state has a 6% income tax rate, so her combined marginal rate on interest income is approximately 30%. A municipal bond from her home state yields 3.2%. The taxable equivalent yield is 3.2% divided by 0.70, which is approximately 4.57%. A taxable bond would need to yield at least 4.57% to match the after-tax return of the muni.

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## Dividend income

Dividends are distributions paid by corporations to their shareholders out of earnings and profits. They appear on Form 1099-DIV. The central distinction, and the one that generates the most planning value, is between ordinary dividends and qualified dividends.

### Ordinary dividends

All dividends received are initially ordinary dividends unless they meet the specific requirements to be classified as qualified. Ordinary dividends are taxed at the recipient's marginal ordinary income rate. For a high earner in the 37% bracket, this produces a significantly worse outcome than the preferential rate available on qualified dividends.

### Qualified dividends

Qualified dividends are taxed at the same rates that apply to long-term capital gains: 0%, 15%, or 20%, depending on taxable income. For 2025, the 0% rate applies to taxable income up to $48,350 for single filers and $96,700 for married filing jointly. The 15% rate applies from there up to $533,400 single and $600,050 MFJ. The 20% rate applies above those thresholds.

To be qualified, a dividend must meet three conditions.

First, it must be paid by a US corporation or a qualified foreign corporation. A qualified foreign corporation is one incorporated in a US possession, one eligible for benefits under a comprehensive US income tax treaty, or one whose stock is readily tradable on an established US securities market. Dividends from corporations in countries that do not have a treaty with the US, or dividends from certain passive foreign investment companies, do not qualify.

Second, the stock must be held for a minimum period. The rule requires that the stock be held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. This holding period requirement exists to prevent investors from buying a stock immediately before the ex-dividend date, collecting a dividend at the preferential rate, and then selling. The ex-dividend date is the date on which a buyer of the stock is no longer entitled to the declared dividend.

Example: Roberto buys 1,000 shares of a US company on July 1. The ex-dividend date is July 15. He receives a $2 per share dividend on August 1. The 121-day measurement period runs from May 15 (60 days before July 15) to September 13. Roberto held the shares from July 1, which is 46 days into the measurement window. He sells on August 15, having held for 45 days within the window. He has not held for more than 60 days in the period and the dividend is ordinary, not qualified.

Third, the dividend must not be from a type of payment that is explicitly excluded. Dividends paid by tax-exempt organizations, payments in lieu of dividends, and certain payments from employee stock ownership plans do not qualify.

### Dividends from specific investment structures

Real estate investment trusts, known as REITs, generally pay dividends that are treated as ordinary income rather than qualified dividends because REITs are not subject to corporate tax at the entity level and their distributions often represent a pass-through of ordinary rental income. A portion of REIT dividends may qualify for the Section 199A pass-through deduction of up to 20%, discussed in Part 3, which partially offsets the loss of qualified dividend treatment.

Dividends from money market funds are interest income, not dividends in the investment sense, even if the fund markets them as dividends. They are taxed as ordinary income.

Dividends from mutual funds can be a mix of qualified and ordinary income depending on the underlying holdings of the fund. The fund reports the qualified portion on Form 1099-DIV, and the investor uses only that portion for the preferential rate.

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## The net investment income tax

The net investment income tax, known as NIIT, is a 3.8% surtax that applies to certain investment income for higher-income taxpayers. It is sometimes called the Medicare surtax, though it is technically a separate levy added by the Affordable Care Act.

The NIIT applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds the threshold. The threshold is $200,000 for single filers and $250,000 for married filing jointly. These thresholds are not indexed for inflation, which means they erode in real terms each year and affect an increasing number of taxpayers over time.

Net investment income includes interest, dividends, capital gains, rental income, and income from passive business activities. It does not include wages, salaries, or net earnings from self-employment. A business owner who is materially participating in their business does not have NIIT exposure on the income from that business.

The practical effect of the NIIT is to add 3.8% to the effective rate on investment income once the threshold is crossed. Qualified dividends that would otherwise be taxed at 20% are taxed at 23.8% for taxpayers above the threshold. Interest that would be taxed at 37% is taxed at 40.8%. The marginal rate on interest income at the highest levels of income is therefore 40.8% for federal purposes alone, before adding any state income tax.

Example: Caroline has $300,000 in wages and $50,000 in interest and dividends. Her modified AGI is $350,000. Her net investment income is $50,000. The NIIT applies to the lesser of $50,000 (net investment income) and $100,000 (the excess of her MAGI over the $250,000 MFJ threshold, though she is a single filer so the threshold is $200,000 and the excess is $150,000). The NIIT applies to the full $50,000 of investment income. She owes an additional $1,900 (3.8% of $50,000) on top of the regular income tax on that amount.

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## What is not taxable

Understanding what falls outside gross income is as important as understanding what falls within it. Several categories of receipts that might superficially resemble income are either excluded from gross income entirely or treated differently.

Gifts received are not income to the recipient. The obligation is on the donor, who may owe gift tax if the amount exceeds the annual exclusion. A payment that is framed as a gift but is actually compensation for services is wages, regardless of what the parties call it.

Inheritances are generally not income when received. The estate itself may owe estate tax depending on the value, but the heir receiving inherited property does not recognize income on receipt. The heir does take a stepped-up basis equal to the fair market value at the date of death, which eliminates any unrealized gain accumulated during the decedent's lifetime.

Life insurance death benefits paid to a named beneficiary are excluded from gross income. Interest earned on those proceeds if they are left with the insurer is taxable, but the principal payment itself is not.

Workers' compensation benefits paid under a workers' compensation statute for occupational sickness or injury are excluded from gross income. This is distinct from sick pay or disability income, which is generally taxable.

Child support received is not income. Alimony treatment was significantly changed for divorce agreements executed after December 31, 2018: alimony is no longer deductible by the payor or taxable to the recipient under those agreements. For agreements executed before that date, the prior rules still apply unless the agreement is modified and the parties elect the new treatment.

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## Key figures for 2025 and 2026

**Top ordinary income rate:** 37% above $626,350 single / $751,600 MFJ (2025); 37% above $640,600 single / $768,700 MFJ (2026)

**Qualified dividend rate at top bracket:** 20% (both years), plus 3.8% NIIT if applicable

**NIIT threshold:** $200,000 single / $250,000 MFJ (both years, not indexed for inflation)

**0% qualified dividend rate:** taxable income up to $48,350 single / $96,700 MFJ (2025); up to $49,550 single / $99,100 MFJ (2026)

**15% qualified dividend rate:** $48,350 to $533,400 single / $96,700 to $600,050 MFJ (2025)

**Group term life insurance exclusion:** $50,000 of coverage

**Dependent care assistance exclusion:** $5,000 per year

**Educational assistance exclusion:** $5,250 per year

**Commuter and parking benefit exclusion:** $325 per month (2025)

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*Next: Part 3 covers self-employment and freelance income, including self-employment tax, Schedule C deductions, the home office deduction, and the qualified business income deduction.*

*This article is published by Antravia Advisory. It is for informational purposes only and does not constitute tax advice. Individual circumstances vary and you should seek advice from a qualified practitioner before making decisions that affect your tax position.*