Gross Income vs. Net Income

Gross Income vs. Net Income

There are two types of income - net and gross. One is what you negotiate, the other is what you can spend. It is important to know the difference between the two when planning your budget. Just because you are getting paid X does not mean you get to spend that entire amount due to taxes and other deductions. To find out how gross pay and net pay are calculated continue reading...

What is Gross Income?

Gross income (or gross pay) is the amount of compensation that an employee receives from their employer before taxes other deductions are applied. It can be stated on an hourly basis, a monthly basis or more commonly on an annual basis (aka salary). Gross income is the amount you negotiate when you take the job. It is the amount any raises are applied to.

For example, an employer pays you a salary of $155,000 / year - that is your gross pay. Another example is a contractor is paid $125 / hour for a job. The contractors hours * 125 = the contractor’s gross income.

Gross Income vs. Net Income

Gross income is the total amount before deductions. Net income (or net pay) is what you have left over after all the deductions. 

What is meant by deductions? Some quick examples are:

  • Taxes (social security, medicare, and income tax)
  • Retirement Contributions
  • Health Insurance
  • Union Dues
  • Employee-specific deductions
  • Incentives

So if your gross pay is $155,000 / year, but taxes are 25% and health insurance is $12,000, you are left with ($155,000 * 0.75) - 12,000 = $104,250.

Another way to look at net pay is the amount you get in your paycheck after the deductions are taken out. For the purposes of budgeting your income is your net pay. Or you could use gross pay as your income, but then you need to include taxes and other deductions as expenses in your budget which makes it extra complicated.

Detailed Deductions from Gross Pay

Deductions from your paycheck reduce your net pay. Some of the deductions are mandatory while others are voluntary.

Mandatory deductions are:

  • Payroll Taxes (federal, state, and local)
  • Medicare Taxes (FICA)
  • Income Tax Withholding (this can be adjusted based on your number of dependants)

Voluntary deductions are:

  • Employee-specific Deductions
  • Retirement Contributions
  • Union Dues (in some cases these are mandatory)
  • Health Insurance
  • Optional benefit programs such as:
    • Life Insurance
    • Short Term Disability
    • Long Term Disability
    • Health Savings Accounts
    • Flexible Spending Accounts

Taxes are mandatory and their amount is determined by formulas published by the IRS, states and local tax authorities. The amount of the tax depends on your gross pay, where you live, and the number of dependents you have.

Employee-specific deductions are costs related to the equipment you need to wear in the workplace and this should be stated in the employment contract.

Incentives are voluntary deductions. They can be short-term or long-term.

Short-term incentives are paid in the form of bonuses at the end of the year if certain goals are met. Long-term incentives are bonuses that are paid out within 3 to 5 years in the form of cash or company shares.

Retirement contributions - it all depends on which pension plan you use, for some you will pay taxes sooner, and later. An employer can offer you a retirement plan within the company you work for.

Health insurance premiums are deducted from your salary, before tax. Some companies offer multiple insurance programs to choose from.

Some of the deductions are taxed before the mandatory taxes are deducted - such as pension contributions and health insurance. Some deductions are deducted only after-tax, and one such deduction is union compensation.

How to calculate your gross pay?

As I have already mentioned, there are two types of gross earnings, and they are:

  • Salary
  • Hourly

This can be paid weekly, every two weeks, twice monthly and monthly. Is it better to be paid by the hour or salary? You can decide for yourself what suits you best.

If the employee's annual salary is $150,000, and we want to calculate the amount of salary that the employee receives on a semi-monthly basis, we will calculate it as follows:

$150,000 / 24 = $6,250

The number 24 is taken for calculation because the employer pays the employee twice a month.

Pay per hour is calculated in a slightly different way. If an employee is paid $25 per hour and works 40 hours a week, his weekly salary is $1,000, which means that he can earn $ 4,000 in a month, if he works 40 hours every week. Although the exact number of work days in a month can vary.

week 1 $ 25x40 = $1000

week 2 $ 25x40 = $1000

week 3 $ 25x40 = $1000

week 4 $ 25x40 = $1000

Salary $4000

Conclusion: I hope this article has served as a guide for you to see the difference between gross and net pay, to find out what they consist of, and how they are calculated.

The post Gross Income vs. Net Income is part of a series on personal finances and financial literacy published at Wealth Meta. This entry was posted in Financial Literacy, Budgeting
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