For individuals, gross income is the total pay you earn from employers or clients before taxes and other deductions. This is not limited to income received as cash, as it can also include property or services received. On the other hand, net income refers to your income after taxes and deductions are taken into account. For companies, gross income is revenue after cost of goods sold (COGS), has been subtracted. That makes a business’ net income equal to profit, or net earnings.
A long-term financial plan should account for your income taxes. Speak with a local financial advisor about your financial plan.
What Is Gross Income?
Your gross income includes more than just your wages or salary. It also includes other forms of income, including alimony, rental income, pension plans, interest and dividends. However, if you simply work one job and receive an annual salary from your employer, your gross income would equal your total annual salary before any taxes or benefits are taken from your paycheck. For example, Mary is a teacher and her salary is $40,000 per year. Her salary is her gross income.
If you’re an independent contractor or freelancer, your annual gross income would be everything you’re paid for the work you complete for clients over the course of 12 months. And if you’re an hourly worker, your annual gross income would be what you earn per hour multiplied by the number of hours you work every year.
What Is Net Income?
Essentially, net income is your gross income minus taxes and other paycheck deductions. It’s what you take home on pay day. To calculate it, begin with your gross income or the amount you earn from all taxable wages, tips and any income you made from investments, like interest and dividends. Then subtract income taxes, insurance payments, contributions to retirement accounts, Social Security and Medicare taxes, and any legal obligations, such as loan payments, child support or wage garnishments.
For example, Mary earns $40,000 per year as a teacher. After she subtracts taxes, insurance payments, her retirement account contributions and any other deductions that come out of her pay, her net income may actually be closer to $30,000. This is her “take-home pay.”
Net income can give you a more realistic idea of how much you can afford to spend, and is a good indicator of how much you will end up paying in taxes each year.
Understanding Taxable Income
When filing your federal and state income tax forms, you’ll use your gross income as your starting point. Then, you can subtract deductions to determine how much you’ll owe.
However, your gross income is not the same as your taxable income. That’s because some income sources are not a part of your gross income for tax purposes. Common examples include life insurance payouts, certain Social Security benefits, state or municipal bond interest and some inheritances or gifts.
Instead, your taxable income is your adjusted gross income (AGI). This is what you earn after subtracting “above-the-line” tax deductions from your gross income. After calculating your AGI, you’ll decide whether to take the standard deduction or itemize your tax-deductible expenses. Depending on your financial situation, one of the two options will reduce your taxable income more than the other.
For your 2020 taxes, the standard tax deductions are:
- $12,400 for single taxpayers and married taxpayers filing separately
- $24,800 for married taxpayers filing jointly
- $18,650 for taxpayers who qualify as heads of household
Your taxable income is what’s left after subtracting standard deductions, and it can be significantly less than your gross income. Your gross income is more than just a starting point on your tax forms, though. That figure is also useful to lenders and landlords so they can determine whether they will loan you money or rent you a property.
How Gross Income and Net Income Can Affect Your Budget
When it comes to your budget, it’s important to know which number to use: gross income or net income. Since your net income is your take-home pay, or the money that you’ll actually earn on pay day, it may be best to focus on that number when creating a budget.
Now that you know how much you take home, look at what that total is during the course of one month. You’ll want to know this number because most bills require monthly payments.
Once you know what you take home every month, start tracking how much you spend every month. Start with your fixed costs, such as your rent or mortgage, utility bills, student loans and anything else that requires a monthly payment.
Next, round up your variable expenses. These may include your monthly grocery bill, gas for your car, credit card bill and any other costs that are typically variable.
Once you have your fixed costs and variable expenses totaled, add the two amounts together to determine how much you’re spending every month. Take this total and subtract it from your total monthly net income or take home pay. Whatever’s left is yours to save or spend. A simple rule of thumb is to save that money every month or use it to pay down high-interest debt. However, if there’s no money left or the number is negative, you may want to consider cutting costs. Consider looking at your expenditures to decide where you can feasibly cut spending.
The 50/30/20 Budget
Consider the 50/30/20 budget if you’re looking to follow a more structured budget. The basic rule of this budget is to spend 50% on needs, 30% on wants and 20% on your savings and/or debts. There is a slight modification to net income for this budget as you’ll add deductions like healthcare and retirement contributions back into your net income.
Next, limit your needs category to expenses like groceries, rent or mortgage payments, utilities, health insurance, necessary transportation expenses and medicine. Although the final 20% is for your savings and debt payments, the minimum monthly payment for any debt you have should go into the needs category. If you don’t make the minimum monthly payment on your debt, it could negatively impact your credit score. This category should equal 50% of your monthly net income.
The wants category includes items like your cable, phone and internet bill. It may also include money for dinners out at restaurants or shopping for items you don’t need. The total for this category should not exceed 30%.
The last 20% goes toward savings and debt payments. That retirement money we added back to your paycheck earlier goes into this category, too. Any additional variable debt payments should as well. After paying those debts, the leftover money can go straight to your savings account.
While your gross income is higher than your net income, you should understand how both affect your taxes and budget. Your gross income helps determine your AGI and taxes, while your net income can help you create your monthly budget. Both are important parts of your finances, so it’s important to know what your gross income and net income are. Taking the time to understand what you earn can help you prepare for a future that is financially sound.
Budgeting Tips for Taxpayers
- Understanding what your gross and net income is, as well as how much you’ll pay in taxes, can be difficult. You can try working with a financial advisor to make things easier, and finding one doesn’t have to be hard. SmartAsset’s free tool can match you with up to three financial advisors in your area in just five minutes. Get started now.
- If you need help creating a budget, try SmartAsset’s budget calculator. Use it to compare your spending habits with similar individuals in your area. Just input your gross income and how much you spend every month to determine how you can budget better.
- If you’re an employee of a company that withholds taxes from your paycheck, you’ll fill out a W-4 form. It’s important to understand how this form affects your take-home pay.
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