Gross vs. Net Income: Understanding the Difference

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Gross income is the total of all income you receive before taxes. It’s also called pre-tax income. Net income is your income after taxes (or take-home pay).

Your gross income figure will always be higher than your net income figure. This basic principle is usually applied to corporate accounting, but the fundamental differences between gross and net income can be applied to personal finance in a way that can help you budget and plan even if you’re not a business owner

What Is Gross Income?

Gross income is your income from all sources before taxes or deductions. As a business owner or self-employed individual, your gross income measures the profit generated from sales alone, using just your total revenue minus the cost to you for the goods sold.

Gross income doesn’t only apply to business owners. It includes your salary or wages as an individual. It also includes income from investments, rental properties, bonuses, tips, self-employment or freelance work and other taxable income sources.

The simple formula for gross income is:

• Total Revenue – Cost of Goods Sold = Gross Income

To calculate your gross income:

• Gather the documents showing your income for the year. For individual workers and the self-employed, this can include W-2s and 1099s. It may also include docs showing your interest, capital gains, dividends, rental income, child support payments or alimony.
• Add all income sources together. This should also include any refundable tax credits or government benefits like Social Security.
• Deduct expenses. If you’re self-employed or a business owner, deduct any business expenses to get your annual gross income.

Say this year you earned:

• $80,000 in salary
• $5,000 in dividends or interest
• $20,000 in rental income

Your gross income would be $105,000.

If you’re a business owner, be sure to use the total income before business expenses or — of course — taxes.

Why You Should Know Your Gross Income

For one, it gives you an overall picture of your profits (as a business owner) and your paycheck (as an individual). Lenders and creditors also use it to determine whether to offer you financing for things like a credit card or personal loan. The higher your gross income, the greater your approval odds.

Lenders may also use gross income to determine your debt-to-income ratio (DTI). This is the percentage of your monthly income (gross) that goes toward your monthly debt payments. The lower your DTI, the better.

What Is Net Income?

If you’re a salaried employee, net income is fairly straightforward. Your net pay is the money that ends up in your bank account after taxes are withheld from your paycheck.

If you’re a business owner or independent contractor, things are a little more complicated. You can calculate your net pay by subtracting all ordinary or necessary trade or business expenses allowed by the IRS from the gross income you earned from your trade or business.

The formula for calculating your net income is:

• Gross income – business expenses = net income

Why Net Income Is Important

For individuals, net income is important since it gives you a more accurate idea of the money you have available to save, invest, spend or pay off debt. You can also use net income when comparing the compensation packages from different jobs.

If one job is offering you a little more money but doesn’t offer health insurance, you should take the time to calculate what your net income would be after factoring in the value of your benefits. If your net pay with that job is lower after factoring in the cost of obtaining your own health insurance, you can see how the higher gross income might not be worth it.

For business owners

Net income is also important for business owners. For example:

• It’s an important method for examining potential stock investments: A company’s ability to limit expenses and convert the gross profits from their business into net profits is a crucial factor to their long-term value as a company.
• It can give you a better idea of your business’s profitability. Great net profits are rarely a bad sign, but a company that’s overly focused on maximizing its bottom line without thinking bigger could be in for trouble.

The Bottom Line

To get your gross income, add up any income sources and deduct business expenses (if applicable). The final number is your gross income (or pre-tax profits). Your net income is your total income after taxes are taken out.

Understanding your gross vs. net income can go a long way toward determining whether you’re making enough money — either as a business owner or as an individual. It can help business owners understand their true profits and expenses. It can help individuals understand their paychecks and whether or not they’re being compensated enough for the work they do.

Joel Anderson contributed to the reporting of this article.

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