Net vs. Gross Income
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.
What is your net vs. gross income situation? What does the net and gross difference say about your financial health and how to improve it? Let’s find out!
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
Before delving deeper into gross and 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?
When it comes to gross versus net income, it's essential to understand what the figures are saying about your finances.
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.
The most significant factor differentiating gross income vs. net income 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
Gross vs. Net Income - 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 net vs. gross income is your first step towards increasing both.
Is net before or after taxes?
Taxpayers must submit their gross income and subtract qualifying deductions to calculate their taxable income. Net income is what you’re left with after you pay income taxes and deductions on your gross income.
How do I calculate gross income from net income?
To extrapolate your gross revenue from net income, you need to know all the expenses and deductions that have been subtracted to reach your net income. For individuals, typically, the information is on the paycheck. For a company, the formula is as follows:
Net income = Gross profit - all expenses (operation expenses, business expenses, taxes, interest on debt, etc.)
What is a good annual net income?
The answer depends entirely on your situation. A good salary in 2021 is a yearly net income of $51,480. This can serve as a guideline for your job search, for example. Ideally, a good net annual income is sufficient to manage your household or business expenses, pay off your debts, and save money.
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