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Updated on Thursday, March 18, 2021
Understanding gross versus net income is an important distinction for budgeting and tax planning. For individuals, gross income represents the money you earn before deductions are taken out. Net income is the amount you actually receive in your paycheck. For businesses, gross income is money earned before expenses, while net income is what remains after taxes and expenses.
Knowing how to calculate each one and what they mean can be helpful for short- and long-term financial planning.
- Gross vs. net income: An overview
- What is gross income?
- What is net income?
- Why gross and net income matter for your finances
Gross vs. net income: An overview
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Understanding the difference between gross and net income matters when planning your budget or estimating taxes. And gross pay versus net pay is fairly simple: Gross pay is the amount earned before taxes or other deductions, while net pay is the amount received.
Gross versus net income calculations provide a before and after snapshot of what’s earned versus what’s paid out to you. The more that’s deducted from your gross income, the more that reduces your take-home pay, or net income. Similarly, the more expenses a business has or the more it pays in taxes, the more that reduces its net income.
Knowing when to use gross versus net income calculations is relevant to financial planning and budgeting. Lenders look at gross income versus net income for making personal and business credit decisions, for example. And both companies and individuals can benefit from understanding how the two amounts compare when making monthly, quarterly or annual budgets.
What is gross income?
Gross income is the total amount, before deductions, that an employee or business earns. But gross incomes can be different for individuals and companies.
Gross income definition for individuals
Gross income is the total amount of money someone earns, which can include money earned through:
- Working for an employer (i.e. hourly wages, salaries, tips, etc.)
- Business activities (including gig or independent contract work)
- Rental payments
How gross income is calculated can depend on how you’re paid. If you’re employed by a company, your gross income may be based on an annual salary, an hourly wage, commissions or some combination of the three. If you’re a freelancer or perform gig work, your gross income is all the money you earn from those types of business activities.
For example, say you make $15 an hour and work a 40-hour work week. Your gross pay would be $600 ($15/hr x 40 hours) for that week. If you freelance and bill three separate clients $1,500, $2,000 and $2,500 at the end of each month, your gross pay would be $6,000.
Gross income definition for companies
In business, gross income means money earned before expenses and taxes are paid. This is a simple gross income definition of how companies tally up the money they make. In a financial statement, the word “gross” can also be used to refer to things like gross profit, gross revenue, gross assets or gross margin.
Companies with employees are responsible for calculating employees’ gross earnings and including this amount on pay stubs each pay period. Again, gross pay is the amount an employee earns and it’s an employer’s duty to keep track of these amounts and withhold the appropriate amount of taxes. If you’re an independent contractor rather than an employee, you’re responsible for determining how much to withhold from your earnings for taxes.
What is net income?
Net income is the amount of money left over after taxes and expenses are taken out. For an individual this is referred to as take-home pay; for a company, it can be referred to as net earnings.
Net income definition for individuals
Your net income is what you get to keep after taxes and other deductions are withheld from your paycheck. If you’re interested in how to calculate net income, you’ll first need to know your gross income and what taxes or other deductions are taken out of your paycheck.
Here’s a very simple example: Assume you earn $50,000 in gross pay annually. You live in Arizona, you’re single, paid biweekly and your gross pay each pay period comes to $1,923.08. If you contribute 10% of your pay to your employer’s 401(k) plan, and then additional deductions are taken for federal, FICA, Medicare and state taxes, your net income could end up being $1,353.10.
Again, this is a simple example and doesn’t include deductions for things like health insurance, group life insurance or disability insurance. The more you deduct from gross pay, the less take-home pay you have. Finally, the net income amount will vary, based on where you live and tax rates.
Net income definition for companies
Net income for companies is the amount of profit that a company can claim after taxes and expenses are paid out. The net income formula is based on total sales revenue, minus deductions. Amounts that can be deducted from gross income to determine net income include:
- Cost of goods sold
- Depreciation and amortization
- Interest expense
- Operating expenses
Net income can also be referred to as net profit or net earnings on a financial statement. All three can be used to describe a company’s bottom line when measuring financial health.
Why gross and net income matter for your finances
Knowing how to compare gross versus net income can help with shaping your personal financial plan. There are three specific areas in which the distinction between gross and net income matters:
- Filing taxes: For individuals, the IRS uses gross income rather than net income to determine your Adjusted Gross Income (AGI). Your AGI represents your gross pay, minus adjustments to income for certain deductions, such as retirement plan contributions or student loan interest paid.Adjusted Gross Income can affect the tax deductions and credits you’re eligible to claim. Being familiar with your AGI and what adjustments to gross income you may be eligible for can help you understand how much you owe in taxes or what you may get back in a refund. AGI can also affect what you owe in state taxes.
- Budgeting: Both gross and net income can be used to make a monthly budget, though net income is a more accurate reflection of the amount of money you’ll have to spend. When creating your budget based on net income, you can consider how much take-home pay you’ll have to cover essential expenses, such as housing or food and what money may be left over for discretionary spending.Basing your budget on gross income, on the other hand, could be problematic since it doesn’t measure how much money you receive in your paychecks. However, your gross income can be useful for tracking your earnings year over year and estimating your federal tax bracket.
- Investing: If you have access to a traditional 401(k) plan at work, making regular contributions from your paychecks can help you build wealth for retirement. These contributions come from your gross pay, allowing you to reduce your taxable income for the year. The more money you contribute, the bigger the reduction, which can affect your AGI calculations.If you don’t have a 401(k) at work, then you could invest in an Individual Retirement Account (IRA) instead. A traditional IRA allows for tax-deductible contributions. Your ability to deduct contributions can depend on your adjusted gross income, filing status and whether you’re covered by a plan.Roth IRAs allow for tax-free withdrawals in retirement but you must qualify to contribute to one based on your adjusted gross income and filing status. Again, adjusted gross income is determined from your gross income.