Gross vs. Net Income in the United States
Posted by Frank Gogol in Work & Income | Updated on August 26, 2022
You might think that income means universally the same thing – money earned through economic activities – but do you know the difference between gross and net income?
Understanding this difference is essential in managing your money, especially when you’re trying to set up a budget during tough economic times.
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What is Income?
In a capitalist society, individuals and businesses have to generate income for themselves to afford to function within the society. The income can be generated through various activities like the sale of products, the execution of services, interest accrued on investments, or the rental of property and other tangible assets.
This income is generally taxed by the government and collected by an agency like the IRS. The tax is used for services rendered to citizens at large like infrastructure upgrades, public schooling, clinics, and other services that fall under basic human rights.
There are also normally other deductions made against your income before you can spend it. Or in the case of businesses, their expenses used in creating their product or service is deducted from the revenue they generate.
Difference Between Gross and Net Income
When you get your paycheck or assess the profit your business made, you should think of it being split into two – gross income and net income. This is the difference between your income on paper, and the money you actually get to take home with you after deductions.
What is Gross Income?
Gross income has almost the same definition when applied to individuals and companies.
Your gross income is the total salary you earn from your employer before tax and other types of deductions are taken out of your paycheck or other sources of income (like rental income). For freelancers or contract workers, gross income is the total amount of income you earn in 12 months.
For example, if John the factory worker has a salary of $25,000 a year, that would be his gross income.
For a company, the business gross income is the total income from all income-generating activities before expenses and taxes are deducted. Other gross items include gross assets, revenue, profit, and margin.
What is Net Income?
But how does your income change when you consider gross vs net income?
Net income is your actual take-home pay, including other taxable income streams, after tax and all the paycheck deductions have been paid from your income. Paycheck deductions include insurance, pension contributions, and social security. What you’re left with and take home would then be called your net income.
For a business, their net income would be similar to profit, after all expenses and taxes are deducted and they are left with their net earnings.
What’s the Difference?
When you consider the difference between gross vs net income, the following example might help to apply these terms to real life.
John the factory worker will earn $25,000 a year as his gross income. Then you calculate how much he needs to pay the government in taxes plus his total pension fund contributions and insurance payments, which totals around $10,000 per year. These deductions are then subtracted from his gross income, leaving him with take-home pay of $15,000 a year. This take-home pay is then called his net income.
Understanding Taxable Income
It’s vital to understand these differences between gross vs net income when it comes to doing your taxes.
While you start off calculating the taxes you owe or are owed by the IRS with your gross income minus your deductibles, it’s important to remember your gross income is not the same as your taxable income.
Not all income streams that make up your gross income are taxable, for example. Things like inheritance, gifts, and life insurance payments aren’t taxable.
Gross taxable income is instead called adjusted gross income (AGI) after you’ve subtracted tax deductibles like Child, Education or Earned Income Tax Credits.
When you are working out your AGI, the IRS gives you the option of taking the standard deduction based on your family status (single, married, or head of household) or you can itemize your tax-deductibles. Itemizing your tax-deductibles might reduce your tax bill more.
In the end, your gross income might be far less than your taxable income or AGI.
How Gross Income and Net Income Can Affect Your Budget
Your gross income might look like a lot of money that you can use to spend on things that make you happy. But don’t fall into the trap of using your gross income to work out your budget.
As explained earlier, your net income is normally the actual physical money you get to spend after all your deductions and tax has been subtracted from your gross income. Your net income should be the number that helps you set up your budget.
After you have calculated your monthly net income, track your spending habits, starting with how much you need for fixed costs like mortgage, loan payments, or utility bills. Then get an estimate of more variable essential costs, like groceries and fuel. Add these two expenses together to determine how much you’re spending each month. Subtract this total from your net income to see what you are left with at the end of the month.
Whatever you are left with is what you can use to spend on non-essential expenses like entertainment, or you can save it up for that dream vacation in the Bahamas. If needs be, you can also use that extra cash to pay off any high-interest debt you might have lying around.
The trouble, however, comes in if you’re either left with nothing or the number you are left with is in the negative. This is an indication you are living far beyond your means and should start looking at your expenses again to see where you can cut costs.
The 50/30/20 Budget
If you’re still not sure how to set up a budget, the most popular method is splitting your income using the 50/30/20 method for a structured way forward.
The principle is quite simple – 50% of your income should be spent on needs, 30% on wants and the final 20% should go to either your savings or paying off debt. You would need to adjust your net income somewhat as deductions like healthcare and insurance would then form part of the 50% needs or 20% categories.
Alongside these deductibles, other items that fall into the need category include:
- Rent/Mortgage payments
- Health insurance and medicine
- The minimum payment on any debts
In the 30% wants category, you should include the following:
- Communication bills (phone, internet)
- Restaurants and take-aways
- Unnecessary shopping
Finally, the last 20% should include:
- Paying off bigger chunks of your debt outside of the minimum payments
- Pension contributions (added back in from your deductibles).
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If there’s one thing we have all learned from the pandemic, it’s that it’s essential to manage a strong budget for your financial security, especially for those rainy days when everything goes wrong.
Understanding your gross vs net income and how they help calculate taxes and budgets forms an integral part of securing financial security.
If you’re struggling to balance the numbers, however, reach out to a finance professional to help you manage your income.
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