Your gross income and your net income are two different figures that are important to know. While you may use your net income for budgeting purposes, for instance, your gross income is what you would need if you're applying for credit or starting your tax return.
Here's what you should know about gross versus net income and why it matters.
Gross Income Explained
As an individual taxpayer, your gross income includes all of the income you receive from all sources. For many people, this might only be your salary or wages from your employer before any taxes and other deductions—such as for health insurance premiums and retirement contributions—are taken out.
Depending on your situation, it may also include investment gains, rental income, interest, dividends, and more.
Net Income Explained
If you're an employee, your net income from your employer is your take-home pay after taxes are withheld and other deductions are made from your gross income.
Calculating your net income from your job is generally easy.
Your pay stubs should list your gross income, all of your deductions, and your net income for the most recent pay period, as well as for all payments you've received year to date.
If you have other sources of income, you'll also add those to your total gross income before you subtract taxes and other deductions to get your total net income.
How Your Income Is Taxed
On your pay stub, you'll see a number of taxes withheld from your paycheck. Employers typically withhold federal and state income taxes; Social Security, or FICA, tax; and Medicare tax.
Your withheld income taxes will vary depending on your gross income and your exemptions. You can adjust your withholdings with your payroll manager using a W-4 form. Social Security and Medicare taxes, however, are fixed at 6.2% and 1.45%, respectively.
Calculating Your Tax Bill
When you file your tax return, you'll start with your gross income and take several deductions to get your adjusted gross income (AGI)—more on that in a minute. Then you'll subtract other deductions to arrive at your taxable income, which is what the IRS uses to determine how much you owe for the year before credits.
If you qualify for tax credits, you'll apply them directly to your tax liability, reducing it dollar for dollar to get your final tax bill for the year.
If you paid more than you needed to, either through withholdings or estimated tax payments, you have two options. You can receive a refund for the difference or credit the amount to the next year’s tax bill. If there's a discrepancy, though, that's what you'll need to pay.
Federal vs. State Income Taxes
The federal government has a graduated income tax rate, which means that taxpayers with higher incomes pay higher rates than those with lower incomes. With state income taxes, however, you may have to pay a graduated income tax, a flat income tax, or no income tax at all.
Taxable vs. Nontaxable Income
Finally, it's important to note that some income is not taxable. Examples include:
- Child support payments
- Alimony payments if you were divorced after Dec. 31, 2018
- Certain employee benefits
- Life insurance payouts
- Municipal bond interest
- Unrealized investment gains
- Financial gifts
- Roth IRA and health savings account (HSA) distributions
When To Use Gross and Net Income
In addition to knowing the difference between gross income and net income, it's also important to know when to use each figure.
For example, if you're creating your monthly budget, you'll typically use your net income because that's the money you have to work with every month. But if you're applying for a loan or credit card, you'll typically use your gross income instead of your net income.
Your gross income is also what lenders use when they calculate your debt-to-income (DTI) ratio, which is the percentage of your gross monthly income that goes toward your debt obligations.
What Is Adjusted Gross Income?
Your adjusted gross income (AGI) is a number that the IRS uses to help calculate your taxable income as well as determine whether you qualify for certain tax deductions and credits. You can calculate your AGI by taking your gross income and subtracting the deductions that you may qualify for.
Examples include student loan interest payments, educator expenses, certain retirement account contributions, and some expenses for self-employed taxpayers.
Gross vs. Net Income for Self-Employed Taxpayers
If you earn self-employment income as a freelancer, independent contractor, or sole proprietor, the difference between gross and net income is a little more complicated.
Your gross income is all of the payments you receive from clients or customers for the year before expenses. If you're a freelancer or independent contractor, clients typically don't withhold taxes from payments made to your business.
Your net income, on the other hand, is what you have left after you subtract all of your eligible business expenses and estimated tax payments from your gross income. This is what the IRS will use to determine your tax liability for the year.
The self-employment tax, which is a combination of Social Security and Medicare taxes set at a 15.3% rate, is calculated using 92.35% of your net income.
The Bottom Line
Understanding net versus gross income is important for your budget, taxes, loan applications, and more. Taking the time to understand how to calculate them and the different ways they affect you can help you be better prepared at tax time—and lead to better decisions about your money management.