Net of tax refers to the amount of money left over after accounting for related tax expenses. Understanding how net of tax works is useful for calculating the amount of money an individual or business entity gets to actually keep.
Whether you take in a salary as an individual or generate sales as a business owner, your income is subject to taxes. Keep reading to learn about net of tax and how it plays a role in your financial life.
Definition and Examples of Net of Tax
The term “net of tax” is the amount of money remaining after taxes have been accounted for. Since taxes are levied against individuals and businesses alike, the concept of “net of tax” applies to both types of taxpayers.
Consider this simplified, hypothetical example of net of tax. Company Y reported $500,000 in gross sales this year. However, it must pay $75,000 in taxes. To calculate the company’s net of tax, you would subtract $75,000 (taxes) from $500,000 (gross sales).
$500,000 - $75,000 = $425,000
So, in this scenario, Company Y would have an income net of tax of $425,000.
How Net of Tax Works
When income passes a certain threshold, that income is subject to taxes. Therefore, an individual or corporation does not actually take in the full amount they earned because they must subtract the cost of taxes.
The state or federal government levies taxes to fund various services, such as transportation, or for social benefits, like Social Security, Medicare, Medicaid, and more. The amount left over after the taxes are applied is known as “net of tax.”
As mentioned, when individuals earn enough income, those earnings are subject to an income tax that will affect their annual net of tax.
The federal government imposes a direct income tax on various types of income, including income generated from investments, such as interest and dividends from stocks and bonds. Recurring types of income, like royalties and rent collected from real estate properties, are also subject to taxes.
Net of tax amounts is affected by how much income is earned with different tax rates applied to certain income brackets. A common form of this is the progressive income tax in which rates increase when income hits a certain threshold. To demonstrate, a taxpayer filing as a single individual can expect the following federal income tax rates for 2021 income:
- 10% tax on income up to $9,950
- 12% tax on income from $9,951 to $40,525
- 22% tax on income from $40,526 to $86,375
- 24% tax on income from $86,376 to $164,925
Your filing status will also affect your net of tax. The above example used a taxpayer filing as a single individual, but the tax implications are different for married couples filing joint returns or for heads of households. For example, married individuals filing joint returns for 2021 were taxed at 10% for income up to $19,900 (compared to $9,950 for taxpayers when filing as a single individual).
Individuals and business entities can increase what they have net of tax in part by reducing the amount of taxes they owe through deductions and credits.
With tax deductions and credits, businesses can keep a higher percentage of their gross revenue. Several types of business expenses are tax-deductible like rent, interest on commercial loans, employee salaries, business insurance, employee benefits, and more.
Tax deductions and credits are also available to individuals, allowing people to keep more of what they earn. For example, individuals can deduct several types of costs, including medical expenses and interest on student loans. Individuals can also improve their net of tax through various tax credits, such as:
- Earned Income Tax Credit: This tax credit provides a tax break to low- to moderate-income workers and families.
- Child and Dependent Care Credit: Available to parents and guardians, this tax credit is useful for mitigating the costs of babysitting and daycare. The credit can also extend to caring for an individual who is physically or mentally unable to care for themselves.
- Lifetime Learning Credit: If you’re seeking post-secondary education, this tax credit can help offset some of the costs of obtaining a degree.
Net of Tax and Retirement
Your income can still be subject to taxation when you retire. Like other forms of income, your retirement savings is also subject to taxation.
Keep in mind how net of tax will affect your finances in retirement. Proper planning can help you understand your tax obligations so you can maximize your income in your golden years.
For traditional 401(k) plans, income taxes are deferred until you withdraw from your account. Any pensions you receive from your employer are taxed, as well.
You will owe federal income tax on each pension annuity and periodic pension payments. If you opt for a lump-sum payout, you are required to pay the taxes on the entire amount when filing your tax returns.
- “Net of tax” is a term that refers to the amount of money remaining after subtracting taxes.
- Net of tax is affected by tax rates, which are determined by several factors, such as income thresholds and filing status.
- Tax credits and deductions can reduce your tax liability, thus resulting in a more favorable net of tax.
- Since income accumulated in retirement accounts or pensions is subject to taxes, individuals should understand how their plans work to determine their net of tax income during retirement.