Quickly, how would you would answer this question: “What’s your income?”
Did you think about the amount of your payday deposit? Did you think about the amount on your income tax return for the year?
One is your net income and the other is your gross income.
Everyone should understand the difference between gross and net income and why both numbers are important in your financial life.
Let’s review some of the common factors that go into calculating your gross and your net income – both monthly and annually.
Monthly Gross Income vs. Net Income
Your monthly gross income is what you earn at your job before any deductions. You can find your gross income on your pay stub. From this number, multiply by the number of pay periods per year and divide by 12 to get your average monthly gross income from that job.
Your monthly net income is your take-home pay – whether you receive a check or have direct deposit set up with your bank account. To calculate your monthly net income, multiply your take-home pay by the number of pay periods per year and divide by 12.
Your gross income can be reduced by items such as:
- Federal income tax withholding
- State income tax withholding
- City income tax withholding
- Social Security & Medicare withholding
- Health insurance and savings plans
- Union dues
- 401(k) contributions
Why You Should Know the Difference on a Monthly Basis
For families and individuals, there are several reasons to know the difference between gross and net income:
Household and personal expenses are going to be paid out of the net income – while the money taken out for taxes, insurance and retirement savings is not available to pay the bills. Most household bills generally cycle each month and it’s easier to create a monthly budget using a monthly new income estimate.
Net Pay Per Hour
By dividing net income by the number of hours worked, you can calculate your net hourly wage. This is a good number to know for both hourly and salaried employees. When making a purchasing decision, you can figure out how many hours you need to work to buy a new TV or big vacation.
Example: Terry works a full-time job at $18 an hour. Payday is every other Friday. Terry earns a gross income of $1,440 over 2 weeks but has the following deductions:
- Income taxes ($216)
- Social Security and Medicare ($81.36)
- Health insurance contribution ($75)
- 401(k) contribution at 5% ($72)
Terry has a net income of $995.64 to use for cash-flow planning. When Terry works on a monthly budget, only about $2,157 ($995.64 x 26 pay periods / 12 months) is available to give, save and spend. Knowing the net income, Terry can budget out how much money is available for each category and for each item.
Terry brings home about $12.45 per hour in net pay ($995.64 / 80 hours).
Annual Gross Income vs. Net Income
Your annual gross income can include many types of income that are above and beyond your paycheck:
- Interest on bank accounts
- Dividends and capital gains on investments
- Child Support
- Income from side businesses
- Income from part-time or seasonal jobs
- Income from rental property
- Annual bonus from employer
- Gains from sale of antiques or collectibles
Why You Should Know the Difference on an Annual Basis
By adding up all the sources of income for your family, you can use this information to:
- Develop an annual budget for your family that includes all miscellaneous income sources
- Develop an action plan for the misc. income so that money doesn’t just fritter away in the bank account
- Plan for annual expenses such as insurance, car registration, Christmas expenses, and vacations
- Develop good tax strategies
- Taxing authorities
- Tax brackets due to changes in income
- Healthcare deductions
- Bonuses and other perks
Example: Terry is considering applying for a different job within the city limits. The new job will have an additional city income tax of 1% and will require about $30 more in gas for the additional miles to the office every pay period. The new job offers lower cost health insurance and Terry is willing to contribute more to the 401(k) plan for the higher match.
The new job pays $21 per hour with deductions for:
- Income taxes, increased by 1% city ($268.80)
- Social Security & Medicare ($94.92)
- Health insurance ($50)
- 401(k) contribution of 6% to get full match ($100.80)
Terry’s gross income will increase each paycheck by $240 ($1680-1440) because the hourly rate is higher ($18 v. $21). However, net income will only increase by $170 ($1165.48-995.64) per paycheck.
Even with the additional $30 gas and higher retirement contribution, Terry will have more money to give, save and spend with the job change.
A Contractor’s Calculations
By definition, a contractor is not an employee and does not have estimated taxes, Social Security, or Medicare withheld from their compensation.
If you work part-time or full-time as a contractor, you should understand what percentage to set aside for taxes based on your household tax brackets. Self-employed individuals are required to pay “both sides” of Social Security & Medicare – so double the percentage of what is deducted from an employee’s paycheck.
Many contractors find it helpful to transfer a calculated percentage of income into a special savings account for taxes to save towards quarterly deposits and avoid a bite during tax season. A tax professional can help estimate tax payments based on income and likely business deductions.
Keep in mind that the calculations in this article are based on a specific set of circumstances, and your results will differ! So make sure to do the math yourself to come to the right figures for you in the current year.
Have you ever thought about the difference between your gross income and your net income in terms of either actual dollars or percentages? What did you do with this information?