All income is good income, right? Yes, but there are some important distinctions to note!
For instance, gross income versus net income: What does that mean, and why is it important? If you have a job and earn a paycheck, it’s critical to understand the difference so that you can properly budget, pay your taxes, and work out the finer points of your financial plan.
Gross Income
Your gross income is everything that you’ve earned during a given time period. That’s your entire paycheck – before deductions are taken out of it, for insurance costs or contributions to a retirement plan, for instance. It also includes other forms of income that you may have received within a given time period (usually a year), such as investment income.
When discussing your salary, for instance, you may say that you earn “$45,000 per year,” or earn $20 per hour.” That is referring to your gross income. You may well earn that much, but there are other factors to take into consideration before you actually know how much your take-home pay is, such as taxes, deductions, and contributions.
That brings us to net income!
Net Income
As you may have guessed, net income is your income that includes taxes, deductions, and contributions. If you earn a paycheck, it’s the final number that the check is for – so, if you earn a salary of $45,000 per year, your actual take-home pay for the year is likely to be lower (say, for example, $39,000). That lower figure is your net income.
It’s the income that you net after all is said and done: After your taxes are deducted, you’ve contributed to a retirement plan, and paid for insurance, or other deductions.
Why is This Important?
Gross income versus net income: Why does it matter? It mostly comes down to filing taxes. Since we pay income tax to the federal government and most (but not all) states, you need to know a baseline income level on which to base how you’ll calculate your taxes.
So, you can start with your $45,000 per year salary, which may put you in a higher tax bracket. But if you take out the deductions, you get down to your net income – which is likely lower, and may put you in a lower tax bracket.
Further, you can likely deduct other things from your net income to potentially help lower your tax liability even more. When all is said and done, you’ll arrive at what is called “adjusted gross income,” or AGI, which you can use to help you figure out your tax liability.
That is the reason that knowing the difference is so important: It may save you big bucks when you file your taxes! And, not to mention, help you properly budget for your expenses.
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