For those just starting out in the world of financial literacy, being able to detail the difference between your gross pay and your net pay is important. Each is used for different things and is calculated using different methods. They are also important for different reasons and depending on your financial situation. You may need to know one or the other for things like loan or credit card applications.
Your gross pay is the total amount you are compensated by your employer for a pay period before any deductions are made. Your net pay is what remains after things like federal and state taxes are taken out, 401(k) contributions and social security payments are made, and is what is deposited on payday.
Understanding the practical differences between the two, as well as when each is used and for what is important. Not only does it give you greater visibility and understanding of your own pay, but it increases your general financial literacy as well. We're going to dig into what gross pay and net pay mean, as well as how they're important to your overall financial health.
What Is Gross Pay
Gross pay is the total amount that you've been paid for a period of work by your employer. It is the full sum of either your standard salary or your hourly wage for all of the hours worked in the previous pay cycle. As an example, if your salary is $36,000 per year, your gross pay each month would be $3,000, and your gross income is $36,000.
You will be able to determine your official gross pay by examining your employment contract or by taking recent pay statements and doing some quick math. If you are interviewing for a position and are given a written job offer, your gross income will generally be stated in that letter. Since income is just your pay for the whole year, figuring your gross income out isn't terribly difficult.
Gross Income For Salaried Employees
If your gross pay from your employer is $4,500 per month, you simply multiply that by the number of months in the year. So, $4,500 x 12 comes out to $54,000. That means your gross income for the year is $54,000. The only variable in this is whether or not you get bonuses, gifts, or other perks with a taxable, monetary value. If you receive things like this in your position, they will need to be included in the calculations for gross income.
It's important to keep track of your bonuses and taxable perks like cash or cash-equivalent gifts. If you are new to a position like this, it may come as a surprise that even though they are "bonuses" or "gifts," you'll still need to pay taxes on them, and sometimes at a different, even higher, rate.
While the hypothetical $54,000 gross income from your salary will be taxed in a particular way based on how you file, if you get a bonus of $5,000, for example, that would have a tax rate of 22% applied to it as of the time of writing. That means you only get to keep an estimated $3,900 of that handsome $5,000 bonus come tax time.
Gross Income For Hourly Wage Employees
Those that work positions where they earn an hourly wage will have a little bit more math to do to figure out their gross income for the year. First of all, it's much easier to figure out your gross income if it's early in the year since you can often use your year-end gross income from the previous year as a solid ballpark estimate of what you'll make this year if you work the same or very similar schedule. To do this, simply look at your final pay statement of the year, and the gross earnings field will show what you made for the whole year.
On the other hand, if your schedule changes constantly or you receive irregular hours, you'll want to make a few calculations to get the information you need. This can be done by starting out with your hourly wage. For our example, we'll use a modest hourly wage of $25 per hour. Then you take your hourly wage and multiply it by the number of hours you work in a week, and for this example, we'll assume a work week with a guaranteed 36 hours. So, $25 per hour, multiplied by 36 hours, gives hypothetical gross wages of $900 per week.
Then you'll need to take that gross weekly wage and multiply it by four to get your gross monthly wages. $900 x 4 comes out to $3,600 in gross wages per month. To finish the calculation, your gross monthly wages get multiplied by 12 to get your gross yearly wages. $3,600 per month for 12 months gives you a gross annual pay of $43,200.
Remember that these calculations are only for schedules with set and guaranteed numbers of hours each week. If your schedule varies considerably, you will need more complex calculations to figure out your annual gross pay. This can be further complicated if your employer doesn't give you any paid time off, paid holidays, or other accommodations. In situations like this, having a day off once or twice a month for a doctor's appointment, a sick day, or just a holiday that you don't get paid for can change your estimates dramatically. The calculated amounts can also change significantly if you receive a raise at some point throughout the year.
What Is Net Pay
Your net pay is the amount that you actually receive deposited on payday or the resulting amount on your physical paycheck. It will always be lower than your gross pay since it is what is left for you after various deductions and contributions. In most cases, you will have a variety of mandatory as well as voluntary deductions and contributions that are taken from your gross pay to result in your net pay. Many are related to your benefits, but some are simply taxes.
The most common mandatory deductions that are taken from your gross pay will be federal income taxes, state or local income taxes, and any specific payroll taxes. Other deductions that will be taken that you cannot avoid are taxes and contributions to Social Security and Medicare, often noted on your pay stub as FICA. If you have any official court-ordered garnishments placed against you, these will also be deducted from your gross pay, and you will not be able to stop them.
There may also be more deductions that are not voluntary but are not mandated at the federal or state level. Some examples of these are employers and positions that require specialized equipment necessary for your job functions, uniform costs required for factory or manufacturing workers, and union dues. In some cases, you may have the option to opt-out of them, but in other cases, they are required and stipulated in your original employment contract.
Some voluntary deductions will include premiums for your employer-provided health insurance and flexible spending accounts for medical, dental, or vision programs. These can often be started or stopped only during specific annual enrollment periods. If you make contributions to a 401(k) savings account, this will also be deducted from your gross pay, though they can generally be stopped or canceled relatively easily.
All of the previously mentioned deductions and contributions will be listed on your payslip or pay stub, so it shouldn't be a mystery where your money is going. The amount that you're left with after all of these items are taken out of your gross pay is your net pay. Net pay is generally used to describe your overall usable income. This is frequently an important number for credit card issuers and lenders, who need to know just how much money you actually bring home.
How Is Net Pay Different From Gross Pay
Your net pay differs from your gross pay in that it reflects the amount of money left for you, after all, mandatory and voluntary deductions and contributions. In some cases, you may be able to change your mandatory federal and state deductions by updating your dependent deductions if you've recently had a child, though how you do this will depend on your company's HR department.
What Is Net Income vs. Gross Income
Comparing your net income to your gross income can help you see what percentage of your pay is being taken for deductions. It can also help you decide if you're contributing too much or too little to your retirement account.
Understanding Gross Pay vs. Net Pay Can Improve Your Financial Literacy
While there aren't too many situations where you'll need highly accurate calculations of your gross pay vs. net pay, you will need them for your yearly tax filings. Other than that, they are simply handy things to know that increase your overall awareness of your financial situation and your general financial literacy.
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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 The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.