When discussing income, you'll hear the terms gross and net income. What's the difference between the two? And when do you use the terms? Read on to find out.
In personal finance, gross income is all your income before taxes, or other deductions are removed. Net income is the gross income minus those deductions and taxes. The same idea is true for companies. Gross income is the profits before deductions, while net income is the profits after they are deducted.
Take a closer look at gross and net income, the differences between the two, and how to calculate them.
Gross vs. Net Income: What You Need to Know
Whether discussing personal or company finances, you will likely come across the terms gross and net income. Examine the differences between these two as well as how to calculate them.
Defining the Terms
The definitions of gross and net income do a very good job of highlighting the key differences between them.
Your gross income is all your income streams. For personal finance, this includes your wages, salary, alimony, interest, dividends, pension plans, rental income, and more. If you freelance or are an independent contractor, your gross income is the payment you receive from clients. Importantly, your gross income doesn't include any deductions or taxes. For most people, your gross income will be what you refer to as your salary. Because of this, you may hear gross income called gross pay. Similarly, net income is sometimes called net pay.
The biggest difference between gross and net income is that net income accounts for taxes and other deductions. Think of it as your take-home pay. Net income accounts for deductions such as:
- Income taxes
- Contributions to retirement accounts
- Insurance payments
- Medicare and Social Security taxes
- Loan payments
- Wage garnishments
- Child support payments
Because your net income deducts all the above expenses, it gives you a better idea of the funds you have coming in. Therefore, it is smart to use your net income, not your gross income, to decide if you can afford something.
Your annual income can refer to either your gross or net income. If it isn't specified, you will have to figure it out from context clues. The part of your annual income that doesn't change is that it is your income for a full year.
The Ideas Are the Same for Businesses
As mentioned, you can use the terms net and gross income for personal finances or those of businesses. They work the same way. A company's gross income (or gross profit) is its revenue minus the money it spent on the goods to sell. Net income (or net profit) also subtracts operating expenses from the gross income.
Other Uses of Gross and Net in Business
Once you understand the concept behind gross vs. net, you can apply the same idea to various other business terms. The following are some common examples of business finance terms using gross or net.
- Gross assets are assets' value before deductions.
- Net assets are the value of those assets after deducting certain liabilities.
- Gross revenue is the revenue before subtracting refunds or returns.
- Net revenue is the revenue after deducting items like refunds and returns.
- Gross profit is the profit margin after subtracting the cost of the goods sold or the cost of sales, nothing more.
- Net earnings or net income is the bottom line left after subtracting all the expenses from the revenues.
- Gross margin is the gross profit divided by the revenue. It is a percentage.
- Net margin is the net income divided by the revenue. It is also a percentage.
Where Does Your Taxable Income Fit Into This?
When talking about gross and net income, the idea of taxable income is likely to come up. But your taxable income isn't your net income or your gross income. It starts with your gross income, but you then subtract above-the-line tax deductions. This gives you the adjusted gross income (AGI).
When filing taxes, you calculate your AGI and then handle your deductions. You can itemize deductions or take the standard deduction. Your taxable income is the number you get after this.
The bottom line is that you use your gross income to calculate your taxable income, but it is not the same thing, nor is your taxable income your net income.
How to Calculate Gross Income
Calculating your gross income can be fairly straightforward, depending on how many income sources you have. It will also depend on whether you want to calculate the annual or monthly gross income.
If you are paid a salary, your annual gross pay would be that salary. Your monthly gross pay would be the salary divided by 12. So, assume you have a salary of $48,000. Your annual gross pay would be $48,000, while your monthly gross pay would be $4,000 (48 divided by 12).
If you are paid hourly, you will have to do simple math. You have to multiply your hourly wage by the number of hours worked. Don't forget to account for overtime as well. So, if you earn $12 an hour and work 35 hours a week, you would earn $420 a week. Multiply it by 52 to get your annual gross income of $21,840.
But remember that if you have more than one income source, you have to account for all of them.
Add All Your Income Sources
Your gross income is simply the sum of all your income sources. So, add up all your income, including:
- Wages or salary
- Freelance income
- Pension payments
- Rental income
How to Calculate Net Income
To calculate your net income, you need to start by calculating your gross income. But then you subtract deductions like taxes.
Net Pay From Wages or Salary
If you earn a salary or hourly wage, your paychecks may already calculate your net pay for you. It will be the gross income you earn minus all the relevant deductions. The following are some of the deductions you may find on your paycheck:
- Federal tax income withholdings
- State income tax withholdings
- Medicare and Social Security taxes
- Retirement savings
- Health insurance premiums
- Wage garnishments
The above deductions are typically made in a specific order on your paycheck, although it doesn't affect the end result. Your employer's payroll or HR team will usually do the following each pay period:
- Calculate your gross pay for the pay period (based on hours worked and hourly wage or salary).
- Deduct pre-tax contributions, such as 401(k) and health insurance premiums.
- Withhold the relevant taxes, including FICA, state, local, and federal.
- Garnish any wages for court-ordered payments.
The result of those calculations will be your net pay for that pay period.
What Your Gross Income Is Used For
While your net income is important, your gross income is used more frequently. You will use it for things such as:
- Applying and being approved for loans
- Being approved to rent a property
- Being approved for a given credit limit
- Negotiating your salary
- Paying taxes
- Budgeting in general
Net vs. Gross Income and Budgeting
When defining the two terms, we mentioned that you should use your net income when deciding if you can afford something. This is also true for any other budgeting consideration. Yes, you could technically use your gross income for budgeting, but it would not give you accurate information. It will likely make you feel you have more money to spend than you really do.
Using your net income for your budget gives you much more accurate information. After all, this is your take-home pay.
How to Budget With Net Income
So, how do you set a budget using your net income?
- Start by calculating your net income if you haven't already done so.
- List all your regular monthly expenses. Include utility bills, rent or mortgage payments, car payments, car insurance, student loans, or any other set expenses.
- Then, list your variable expenses. These are things such as gas for your car, groceries, and your credit card bill. When making a budget, it's the best practice to round up. This will account for unusually high costs. In the worst-case scenario, you just have extra money left in your budget.
- Subtract the variable and fixed expenses from your net income.
- The amount you have left is your fun money or the funds you can do anything with. Ideally, you also want to save money every month.
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Gross income refers to your wages and other income sources before accounting for deductions like taxes or health insurance. Net income is your take-home pay, so it includes those deductions and withholdings. When budgeting, consider your gross income. Lenders, landlords, and credit card issuers will use your gross income when deciding whether to approve you. You also use a variation of your gross income when filing your taxes.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.