Regardless of whether you run your own business or work for someone else, knowing your gross income versus net income is key to understanding your financial situation. These two general terms may appear when you file taxes, apply for a loan, or take out a mortgage.
Gross income refers to the total amount of income you or a company receive in a given year before deduction and retention, while net income is the amount of income that remains after all other expenses have been taken into account. Since net income deducts all of your expenses, this net profit is almost always less than your gross income.
Before you create a plan for your budget, company, or investment, let's take a closer look at these two important terms and how to calculate them.
What is gross income?
Gross income is the total amount of income that a person or business earns each year before deduction and retention. For individuals, gross income includes wages, salaries, pensions, interest, dividends, and rental income. For companies, it is revenue from all sources – basically everything that is included in the income statement.
You may be asked to provide your gross income to your landlord, accountant, or lender. Here's how to calculate it.
Calculation of gross income
Gross income is calculated similarly for companies and individuals: add up the various sums of money you have generated over the course of a year, minus any costs or adjustments.
When calculating personal gross income, you should add your wages (including all bonuses and tips) to income from real estate, shares, maintenance, pensions and taxable benefits. You can determine the amount you're taxed on by subtracting all deductions, e.g. B. Student loan interest. It is worth noting that some sources of income are not taxed – such as: B. Insurance payments, inheritances and gifts.
For business owners, gross income is calculated by subtracting the specific costs that are directly related to the creation of your product or service, e.g. B. the raw material costs. Other expenses that are not directly related to the product or service, such as overhead such as rent, utility bills and administrative bills, should not be deducted.
Here's an example:
Jane works for a wildlife charity and her salary is $ 3,000 a month. She rents her guest room at Airbnb, which gives her an additional income of $ 900 a month. Then she deducts the interest on her student loan ($ 150), which is a deduction above the bottom line to generate a gross monthly income of $ 3,750.
Total Income ($ 3,000 + $ 900) – Deductions ($ 150) = Gross Income ($ 3,750).
Jane's gross monthly income is $ 3,750 before tax and deduction.
What is the net income?
The net profit is the remaining income after deducting expenses from total sales. In other words, the net income is the amount you earn after taking all of your expenses into account. Like gross income, net income can be calculated for your personal finances or for a company.
For individuals, you can use net income to see how much you will take home after considering the expenses required to generate income. In business, the net result evaluates the actual turnover of the company taking into account all costs. A company with a positive net income makes a profit. If the net result is negative, the company is operating at a loss.
Calculation of net income
To calculate your personal or business net income, sometimes referred to as net profit, deduct your expenses from your total income for the year. The expenses include everything that has to do with work or business.
When calculating personal net income, commuting costs, work clothes and income taxes should be deducted. For the company's net profit, all operating costs, salaries and additional costs should be deducted from total sales.
Here's an example:
Assume that Jennifer’s jewelry company had sales of $ 50,000 this quarter. With her business expenses including operating expenses, employee salaries, inventory and taxes of $ 20,000, her net income is $ 30,000.
Total Revenue ($ 50,000) – Total Expense ($ 20,000) = Net Income ($ 30,000)
Jennifer's jewelry company made a profit of $ 30,000 this quarter that she can reinvest in the business.
Understand the differences between gross income and net income
While gross income shows the actual income of a person or a company, net income more accurately reflects the pay to go. This is because net income takes deductions and taxes into account, but gross income does not.
Gross income can tell you about your company's financial health by giving you an instant picture of how much revenue your business is generating. The number is often converted into a percentage known as gross profit or gross margin.
Net income can help you calculate a company's value for money – which is helpful for investors. The price-earnings ratio (P / E ratio) measures a company's current share price with earnings per share. In general, a high P / E ratio means that investors expect higher growth in the future. If a company doesn't have a P / E ratio, it loses money.
How both can affect your taxes and investments
Your gross and net income can affect your taxes and other financial decisions such as your investments. When preparing your taxes, calculate your net income. It is therefore important to take into account the deductions you may be entitled to, e.g. B. Travel and office expenses.
If you understand both your gross income and your net income, you can also determine where and how you should invest your money, e.g. B. Estate planning and 401 (k) investments. For example, investing pre-tax money in a company 401 (k) may be more beneficial than contributing after-tax money to an IRA.
Regardless of whether you are an entrepreneur or a single employee, financial literacy is important to drawing up a budget and investment plan. Knowing the most important terms and how they affect your wallet can help you make the most of your hard-earned money.
Swell: Investopedia 1, 2nd