Gross income and net income aren’t just terms for accountants and other finance professionals to understand. As it turns out, knowing the ins and outs of gross and net income can help you in a variety of ways. When you understand the differences between these concepts and how they relate to your money, you’ll be better equipped to evaluate your financial situation and plan your spending and saving strategies.
When it’s time to draft a budget or start setting financial goals for your future, understanding how gross income and net income work — along with the differences between them — is vital. Take a look at the basics of these types of income to get started.
What Is Gross Income?
Gross income is the total amount of income you earn before any funds are taken out for taxes and other deductions you have to pay. Along with income from your employer, your gross income also includes any other form of income you earn through outside sources, such as rent money you receive from tenants who live at your investment property.
Similarly, gross annual income is the total amount of money you earn during the year from your employment and other sources — before any deductions are taken out. On a paycheck, gross income is often written as “gross pay” and lists the total amount of money your employer paid out to you before taxes.
Your gross income gives you an idea of your overall ability to earn money. It can help you determine whether you’re in a good financial place to borrow money, rent a house or enter into a similar contract based on what you can afford to pay.
How to Calculate Gross Income
It’s important to be able to calculate your gross income, as you’ll need the final figure when filing your income taxes, applying for a loan or renting a property. You’ll also need it to calculate your net income. Luckily, the formula is quite simple.
Your gross income is the total amount of money you earned before taxes were taken out and any other deductions were made. This might exclusively be your annual salary or wages if your job is your sole source of income. However, if you have other sources of income, you need to take them into account as well. This includes any interest income earned and dividends on stocks, to name a few.
To calculate your gross income, create a comprehensive list of your total income amounts from all sources, including but not limited to your employment paycheck, before tax and other deductions. Add them together to determine your total gross income.
Examples of Gross Income Items
The most common form of gross income item is your work paycheck. This might include commission and bonuses along with your regular wages or salary. There are also many other sources of gross income to consider. Under the Internal Review Code, all sources that aren’t specifically exempt from taxation contribute to your gross income. Examples of these sources include:
- Rental income
- Capital gains
- Selling products online or in-person (such as through an ecommerce site)
- Gambling winnings
What Is Net Income?
Net income is what is left over after tax and other deductions have been taken from your gross income. Sometimes called “disposable income” or “take-home pay,” this is the money left over after you’ve paid taxes out of your gross income and any other necessary deductions have been made from your gross income. Along with taxes, your health insurance costs and retirement plan investments can also be deducted from your gross income. Note that these deductions don’t include living expenses, such as loan repayments, groceries and electricity bills.
How to Calculate Net Income
The first step is to calculate your gross income following the method outlined above. Once you have this figure, you then subtract your total deductions. These may include your retirement contributions, medical and dental expenses, and taxes. Whether or not you can include retirement contributions and health expenses will depend on your personal financial arrangements. When in doubt, contact the IRS to find out exactly what deductions apply to your situation. Your net income will be the final figure you have left after subtracting all your taxes and deductions from your gross income.
Examples of Net Income Items
Income taxes are the most common deductions to consider when calculating your net income. But there are also other deduction items to be aware of that you may be able to subtract from your gross income. These might include:
- Health and life insurance premiums
- Job-related expenses, such as travel, training or uniforms
- Child support payments
- Retirement contributions
- Flexible spending account contributions
- Wage garnishments
- Health savings account contributions
Why Are There Different Types of Income?
Though there is a major difference between gross and net income, both are important. Your gross income evaluates your capacity to bring in income overall. It helps you streamline all of your income sources and assess your current inflow.
Your net income, in contrast, lets you know what your spending power is. That’s because you’ll know the figure you actually have available to spend after you take care of the taxes and deductions you’re required to pay. Your net income also gives you an idea about how much you’ll pay in annual taxes.
Which Income Type Should You Base Your Budget On?
When it comes to gross income vs. net income and creating a budget, one is a more effective choice than the other. While your gross income reveals important information about your ability to earn money, you should always base your budget on your net income.
Taxes and other deductions have already been subtracted from your net income. This means the figure you’re left with is your disposable income — the actual amount of money that’s available for you to spend. The significant difference between gross and net income is your gross income might reveal how much money you’re earning, but not how much you’ve got to spend. Why? You can’t spend money that will automatically be deducted for taxes and other expenses.
To create a monthly budget, make a list of your monthly fixed costs, such as rent/mortgage payments and student loans. Then, total your variable expenses, such as your grocery bill and other flexible costs. Add these two totals together to work out how much you typically spend each month. Finally, subtract this figure from your monthly net income, and the result will be the amount you have left to either spend or save from your budget.