Net vs. Gross Income: Key Differences

Whether you're an employee or an employer, you will come across the terms “gross income” and “net income” as part of your finances. The most important thing to know is that they are not interchangeable.

Gross income is the larger number, representing your total income before deductions and taxes. Net income is the smaller number you get after paying taxes and deductions. Understanding the information either type of income provides about your finances is essential.

For example, this difference affects your taxes. It also determines your business net profit. It represents the difference between your paycheck and the amount of money you've got left for expenditures.

Defining Gross vs. Net Income

It is important to understand exactly what the terms mean and what the formulas for calculating these two incomes are.

What Is Gross Income?

Companies refer to gross income as gross margin or gross profit. It encompasses the total revenue generated by a business or person over a specific period (a year, quarter, month, etc.) through sales minus COGS (cost of sold goods), but without taxes. 

To calculate your gross income as a business owner, you can use this formula:

Gross profit = Gross Revenue - COGS

An employee’s gross salary appears directly on their paycheck. It is the total amount of wages you receive from your employer before withholdings and additional costs. If you add the gross pay for a year together, you will get your gross annual salary.

What Is Net Income?

Once they take out taxes and other deductions from their wages, salaried employees are left with their net pay or income. If you are paid monthly, this is your monthly net income.

To calculate their company’s net profit, businesses need to deduct all business expenses, like sales costs, marketing, payroll, and taxes, from their gross profit. Since the COGS was already taken away from the total revenue to calculate the gross profit, you won’t need to deduct that again.

To calculate net income, you can use this formula:

Net profit = Gross profit - Total expenses

Why Are Gross and Net Income Important?

A company’s or individual’s gross income is what’s taxed. It’s also what they submit when applying for loans, be they business loans or personal lines of credit. The higher its gross income, the better an entity’s chances of getting reasonable rates.

For example, a business looking to increase its gross income can consider additional revenue streams, expanding its client base, hiking up rates, or buying cheaper goods. If employees wish to improve their gross pay, they need to seek a role or employer that pays better gross wages.

On the other hand, the net income highlights the financial health of a company or a wage earner. For instance, if your gross income grows year-or-year, but the net income remains the same, it’s a sign that your total expenses and deductions are increasing, and you’re not actually left with more money than before at the end of the day.

Increasing Your Net Income

As mentioned, deductions and expenses can affect your net income, which is essentially the money you've got available at the end of the period (a month, a year, etc.). So, as valuable as your gross earnings are, if you want more money in your pocket at the end of the year, you need to build an all-encompassing income-boost strategy.

There is no miracle formula, unfortunately, and essentially it boils down to lowering your overhead. For example, companies can decrease the cost of sold goods by:

• Switching to cost-effective materials for goods production
• Increasing prices to boost sales revenue
• Reaching out to new clients to increase sales volume

On the other hand, employees have limited opportunities to improve their gross - and therefore net - salaries. They can either change jobs or secure a pay rise from their employer. However, with a higher salary come more responsibilities and expectations.

In other words, an employee often needs to invest in their skills before earning more, which can take too long.

Income Deductions

The most significant factor differentiating the two incomes is the number of deductions.

Both companies and individuals need to review their total expenses to identify those that could be reduced. Understandably, some expenses are non-negotiable, such as business insurance premiums or rent.

However, businesses have more leverage to reduce costs through transformations, new investments, and strategic improvements.

On the other hand, employees and freelancers are likely to have essential withholdings they can't and shouldn't cancel:

• Health, Dental, Vision insurance premiums
• 401(k) contributions
• Social Security and Medicare taxes
• Federal income tax
• Local income tax
• Union dues
• Savings account contributions

In Conclusion

Both gross income and net income define your finances, and you’ll use both often, on your income taxes, paycheck, business profits, and loan applications. As a rule, gross income is the bigger number while the net is the smaller one. Understanding the differences between them is your first step towards increasing both.