Net Income vs Gross Income
Whether you run a business or work for an employer, it’s good to understand the difference between gross vs net income. Understanding the difference gives you a much better understanding of your current financial situation. These terms show up when filing taxes, getting a mortgage, and applying for loans.
Before you can start planning a budget or investments, you should knot the ins and outs of net income vs gross income. Let’s take a look at these terms and the key difference gross, and net income have.
What is Gross Income
Gross income represents the total amount of income generated by an individual or business before removing deductions and withholding. The gross income of an individual includes their salaries/wages, pensions, interest, retail income, and dividends. For businesses, gross income covers income from every source – everything listed on your income statement contributes to your gross income.
Your landlord, lender, or accountant may ask you for your gross income. Here’s how you can calculate yours;
Gross income = total income – deductions.
Individuals and businesses both calculate gross income in a similar fashion – add all the sums of money generated over the year and remove adjustments and costs.
When trying to calculate your gross personal income, be sure to include any wages (including bonuses and tips), income from properties, alimony, pensions, taxable benefits, and shares.
You can calculate how much you’ll be taxed on by removing above-the-line deductions from the amount, such as interest on student loans. Please note that not every source of income is taxed. Gifts, inheritances, and insurance payouts are not taxed.
Business owners can calculate gross income by subtracting costs directly related to creating products and delivering services, such as the costs for raw materials. You should not deduct other expenses not directly related to your products and services, such as rent, utilities, and administrative costs.
Let’s look at an example.
John earns $3,000 per month at an animal sanctuary. He lists the spare room in his house on Airbnb, generating an extra $900 per month. He’s still paying off his student loans, so he deducts the interest ($200) as an above-the-line deduction.
So, John would use the following equation to calculate gross income;
Total Income ($3,900) – Deductions ($200) = $3,700,
John has a gross income of $3,700 before deductions and taxes.
What is Net Income
Your net income is the amount of money left over after removing expenses from the total revenue. A big difference between gross income vs net income is that net income refers to how much money you have after accounting for all factors. Net income can also be calculated for both businesses and individuals.
On the individual level, net income shows you how much money you take home after removing expenses necessary to make that money. For businesses, net income determines the actual revenue of a company by weighing expenses against income. Companies with positive net incomes are making a profit, while companies with a negative net income are operating at a loss.
Calculating your net income, also referred to as net profit, you’ll want to take your total revenue and subtract all expenses related to your business or work.
For personal net income, things such as income taxes, commuting costs, and uniform costs are included. For businesses, be sure to deduct operating costs, worker salaries, and other additional expenses.
Let’s look at an example.
Kenny runs a t-shirt company. His company generated $700k for the year. Kenny ran up business expenses of $200k across operating costs, inventory, taxes, and salaries.
Kenny would have made a total net income of $500k (700-200) and can invest that money however he sees fit.
There are several differences between net vs gross income. Gross income is how much money you – or your business – make before removing deductions. Net income refers to how much money you have after factoring in deductions and other costs.
Personal gross income is how much money a person earns before paying taxes. Net income is how much money they actually take home after paying taxes.
Gross income gives you an immediate snapshot of the financial health of your business by showing how much money you generate. Net income shows you how much money your business actually generates.
To summarize, the main difference gross and net income have is that one represents your finances as a whole, and the other represents finances after removing taxes and other deductibles.
How Gross Income and Net Income Can Affect Your Budget
It’s vital you understand the differences between gross vs net and use both figures when calculating a budget. If you have a high gross income, you might think you have a lot of money to invest. However, looking at the net income paints a much smaller picture.
It’s natural to have a smaller net income, but if your net income is too low, it could be time to cut down on your expenses. On the other hand, if you have a healthy amount of net income, you can find ways to re-invest it to generate more gross income for a better profit margin in the future.
You should understand both figures and how they represent your financial situation.
The 50/30/20 Budget
The 50/30/20 budget refers to one of the most popular budgeting methods. It requires splitting your budget into three categories; wants, needs, and financial goals. The idea was popularized by Senator Elizabeth Warren. While you might need to adjust the specific percentages according to your needs, here’s how the rule generally breaks down;
50% of income goes towards needs Roughly half of your budget should go to the financial needs, the things you can’t live without. This includes groceries, rent, and utilities such as water and electricity.
- 30% of income goes towards wants
These “wants” are things that make life more comfortable, but you don’t necessarily need them to live. This includes things like vacations, hobbies, eating out, and money spent on streaming services, etc.
- 20% of income goes towards financial goals
The final 20% of your income goes towards financial goals. These are split into two groups – all savings, such as saving for a home or retirement and paying off debts.
Because the 50/30/20 rule is a guideline that you use when planning a budget, you’ll still need a budget monitoring solution to ensure you stay the course. If you’re having trouble coming up with a potential budget, then this simple solution could be the answer for you.
While gross income is typically higher than net income, you should understand the differences between net vs gross income. These differences are vital when budgeting and paying taxes.
Gross income helps to determine taxes, while net income helps put together an effective budget. Both gross and net income are vital parts of the financial process. You should know what both of these figures are for your business and what they mean. Using the two together is the key to creating a financially sound future for yourself and your business.