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Diversification of rural households into the nonfarm economy is a key driver of economic growth and structural transformation in countries where agriculture remains the primary source of livelihood. This study examines trends and patterns of income diversification, its determinants, and its association with household welfare in rural Ethiopia. Our analysis indicates that rural households in Ethiopia continued to rely primarily on farming, with only marginal diversification of income sources during 2012–2019, despite the broader context of rapid economic growth. Crop production remains the main source of income, followed by livestock, while nonfarm activities contribute 17–24% of total household income. Factor endowments and local conditions, including rainfall, play a crucial role in shaping diversification decisions. In particular, the 2015–16 drought appears to have pushed households to increase engagement in nonfarm income-generating activities. Importantly, income diversification is associated with higher household consumption, improved dietary diversity, and better housing quality, highlighting the potential of expanding the rural nonfarm economy to enhance household welfare.