Whether you’re an employee or own a business, gross income and net income are important concepts to grasp. Understanding the difference will help you file your taxes as a wage earner, or understand the health of your company as a business owner.
They’re often confused, so we’ll breakdown the meaning of both concepts with examples to help you apply it to your finances.
What Is Gross Income?
As an employee, your gross income is the wage or salary that you earn before taxes and deductions are taken out of your paycheck. This is the pay that you accept in your job offer, thus, the total cost that your employer pays you for your position at the company. For example, if your job offer letter stated that you earn $71,000 annually, that is also considered your gross income.
Your gross income matters when you’re filing your federal and state tax return to help determine your deductions. If you apply for a loan, lenders will also look at a combination of your gross income and credit score to determine the amount that you qualify for.
Gross income takes on a different meaning for business owners, as it’s the revenue minus the costs of goods sold (COGS). This reveals how much the company has made off of its offerings after subtracting the costs required to provide the service or make the product.
For example, if your company revenue was $700,000 in 2018, but it costs $300,000 to provide your service or make the product, your gross income is $400,000.
What Is Net Income?
As an employee, your net income is important when it comes to managing your monthly budget — it’s the amount you see in your paycheck or your total take home pay once your taxes and deductions have been taken away. Typical deductions from your gross income include federal, state and local income tax, social security and medicare contributions, as well as your chosen pre-tax deductions for medical insurance, dental insurance and more.
For example, if your gross income is $71,000, but you have $21,000 in annual deductions, your net income is $50,000.
If you’re a business owner, your net income is the profit earned for the company after all taxes and expenses have been deducted from the revenue. For example, if you’re a retailer and sold 7,000 products at $100 each, your revenue is $700,000. If it cost you $250,000 to make the product, your gross income is $450,000. If your taxes and other expenses equate to $100,000, your net income is $350,000.
What Is the Difference Between Gross Income and Net Income?
If you’re an employee, gross income is your total income before deductions, while net income is your total take home pay after deductions.
If you’re a business owner, gross income is your revenue minus the cost of goods sold (COGS). Your net income is the profit earned for the company after all taxes and expenses have been deducted from the revenue.
How Is Calculating Your Gross Income and Net Income Useful?
Calculating your gross income and net income helps determine your financial health, and could help you determine as to what changes in your budget you should make in the following year.
If you’re an employer, you may want to see if you qualify for additional tax deductions, so your net income is higher next year. As a business owner, you might find that another manufacturer is less expensive, thus providing you with a higher net income.
Whatever your financial goals may be, understanding the difference between gross income and net income is the first step towards predicting your growth for next year.