Do you know the difference between “gross income” and “net income”? For starters, while they both have a similar baseline, gross income refers to the “big” amount of money on your income statements while net income is the “small” one.
Thinking about it this way makes it easy to understand, but if you’re serious about managing your money, there’s more to learn. In today’s article, we’ll be taking a deep dive into gross income and net income. Also, we’ll discuss the relationship between income and budget and how you can manage your expenses more effectively!
Understanding gross income
Gross income is the total amount of money you earn before any deductions or taxes are taken out. Gross income can be comprised of active income, passive income, or both. Active income is the money you receive in exchange for your work. This type of income is commonly earned in the form of wages, salaries, tips, and commissions. Passive income, on the other hand, is obtained with little or no effort and includes rental income, alimony, interest, and dividends.
If you’re a full-time employee with no additional streams of income such as a side project or job, your gross income will be solely made up of your salary, and any additional tips or commissions.
Here’s an example:
Tessa is a sales representative for a cosmetics brand, her salary is $40,000 per year, and she also gets a yearly bonus of $3000. As a result, her gross income is a combination of a fixed salary and a bonus, which equals to $43,000.
If you’re a freelancer or independent contractor, your gross income is calculated by combining all the work you have completed for your clients over the course of 12 months. It’s noted that the payments you receive from each project are different due to a project’s sizing and complexity.
And if you’re an hourly worker, your annual gross income would be your hourly rate multiplied by the number of hours you work every year. For example, if your hourly rate is $8, and you have completed 1500 work hours, your gross income would be $12,000.
Passive income is generated without requiring a person to be physically present to make money. Instead of trading your time and labor for money, by making an initial investment, you can make a living passively. Rental income, interest, and dividends are passive income sources that can bring in a steady profit.
Understanding net income
Net income is the remaining money after deductions and taxes have been subtracted. That is the money that you put into your pocket on payday. It’s the amount you’d get if you cashed your check, or if you use direct deposit, it’s the amount deposited in your bank account.
Not everyone’s obligation is to pay taxes, but if you’re earning a certain amount, you’ll have to file taxes. However, not all sources of income will be taxed. It’s important to know what is taxable and what is not.
According to IRS, these income sources are counted as taxable income:
- Wages, salaries, tips, and other taxable employee pay
- Union strike benefits
- Long-term disability benefits received prior to minimum retirement age
- Net self-employment or freelance earnings under certain circumstances
- Jury duty fees you earned
- Security deposits and rental property income
- Awards, prizes, gambling, lottery and contest winnings
- Back pay from labor discrimination lawsuits
- Unemployment benefits
- Capital gains (there’s an exception for the selling of a property that’s your primary residence)
- Severance pay from a previous job
- Alimony from an ex-spouse
- Interest or dividends from investments
- Royalties and license payments
- Canceled debts (but there are key exceptions for those declaring bankruptcy)
Types of income that are not taxed include:
- Workers’ compensation benefits
- Child support payments
- Life insurance proceeds unless the policy was turned over to you for a price
- Disability benefits (if you contributed to the premiums from your salary)
- Social Security benefits (depending on your filing status and other income)
- Capital gains on the sale of your primary home (up to certain thresholds)
- Money received as a gift or other inherited assets (the exception here is, if you’ve earned money as a result of that gift, you owe taxes on those earnings)
- Canceled debts intended as a gift to you
- Scholarships or fellowship grants
- Foster care payments
- Federal income tax refund
- Money rolled over from one retirement account to another via trustee-to-trustee transfer
How does your income affect your budget?
A budget is a spending plan that allocates personal income towards expenses, savings, and debt repayment. This tool allows you to stay in control of your spending and not get into debt. When it comes to budgeting, it’s important to know what number to use: gross income or net income. As net income is the actual amount you have, it should be used as a base to create a budget rather than gross income.
Once you know how much you take home every month, start tracking how much you’re spending. Start with your fixed costs, such as your rent, and any regular monthly costs that are usually about the same amount, such as utility bills. Next, gather all the bills for variable expenses such as groceries, personal care expenses, entertainment, etc. Be careful with your variable expenses because it fluctuates month to month. Play it safe by making sure there’s always a limit for these expenses.
It’s important to keep track of your bills in order to ensure you’re staying on budget, but eventually, these piles of bills can take up a lot of space. It can also be frustrating and time consuming to extract data from each bill to add to your monthly spending report. But don’t worry, we have the perfect solution for you —an expense tracker app!
Shoeboxed is an expense tracker app that stores all your bills on the cloud and allows you to easily compile them into a report. All you have to do is scan your bills, organize them the way you want, and you’re good to go. Shoeboxed will make your expenses tracking and management a breeze!
The bottom line
Some people often confuse gross and net income, which can be detrimental when doing taxes and budgeting. Therefore, having a solid grasp of gross and net income is vital to ensure you meet your financial goals.