Whether you’re running your own business or working for someone else, knowing your gross income vs. net income is key to understanding how you’re doing financially. These two common terms may show up when you’re filing taxes, applying for loans, or getting a mortgage.
Gross income refers to the total amount of income you or a business receives in a given year before deductions and withholding, whereas net income is the amount of income left over after all other expenses are factored in. Since net income deducts all of your expenses, this net profit is almost always a smaller amount than your gross income.
Before you make a plan for your budget, your business, or your investments, let’s take a closer look at these two important terms and how to calculate each.
What is Gross Income?
Gross income is the total amount of income that an individual or business earns each year before deductions and withholding. For individuals, gross income includes wages, salaries, pensions, interest, dividends, and rental income. For businesses, it involves revenue from all sources — basically anything found on the income statement.
You may be asked to provide your gross income to your landlord, accountant, or lender. Here’s how to calculate it.
How to Calculate Gross Income
Gross income is worked out similarly for businesses and individuals: by adding the different sums of money you’ve generated during the course of a year minus any costs or adjustments.
When calculating gross personal income, you should add your wages (including any bonuses and tips you receive) to income from properties, shares, alimony, pensions, and taxable benefits. You can find the amount you’re taxed on by subtracting any above-the-line deductions such as student loan interest. It’s worth noting that some sources of income are not taxed — such as insurance payouts, inheritances, and gifts.
For business owners, gross income is calculated by subtracting the specific costs that are directly related to creating your product or delivering your service, such as the cost of raw materials. Other expenses that are not directly related to the specific product or service, such as overhead costs including 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 per month. She rents out her spare room on Airbnb, which gives her an additional income of $900 per month. She then deducts the interest on her student loan ($150), which is an above-the-line deduction, to arrive at 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 deductions and taxes.
What is Net Income?
Net income is the income remaining after expenses are deducted from the total revenue. In other words, net income is the amount you make after factoring in all of your costs. Like gross income, net income can be calculated for your personal finances or a business.
For individuals, net income allows you to see how much you’re taking home after you factor in expenses necessary to earn the income. In business, net income evaluates the company’s actual revenue by factoring in all costs. A company with a positive net income turns a profit. If the net income is negative, the company is operating at a loss.
How to Calculate Net Income
To calculate your personal or business net income, sometimes also referred to as your net profit, you will subtract your expenses from your total revenue for the year. Expenses include anything related to work or business.
When calculating personal net income, commute costs, work attire, and income taxes should all be deducted. For business net profit, all operating costs, salaries, and additional expenses should be deducted from total revenue.
Here’s an example:
Say Jennifer’s jewelry company brought in a revenue of $50,000 this quarter. With her business expenses, including operating costs, employee salaries, inventory, and taxes at $20,000, her net income is $30,000.
Total Revenue ($50,000) – Total Expenses ($20,000) = Net Income ($30,000)
Jennifer’s jewelry company made $30,000 in profits this quarter, which she can invest back into the business.
Understanding the Differences Between Gross Income and Net Income
While gross income shows the actual earnings of an individual or business, net income is a more accurate reflection of take-home pay. This is because net income factors in deductions and taxes, whereas gross income does not.
Gross income can tell you about the financial health of your business by giving you an immediate picture for 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 price-to-earnings ratio — which is helpful for investors. The price-to-earnings ratio (P/E ratio) measures a company’s current share price against its per-share earnings. In general, a high P/E ratio means investors are expecting higher growth in the future. If a company doesn’t have a P/E ratio, they’re losing money.
How Both Can Impact Your Taxes and Investments
Your gross and net income can impact your taxes and other financial decisions like your investments. When preparing your taxes, you’ll be calculating your net income, so it’s important to be aware of deductions you might be eligible for, such as travel and office costs.
Understanding both your gross income and your net income can also help you determine where and how to invest your money, such as estate planning and 401(k) investments. For instance, it might be more beneficial for you to put pre-tax money in a company 401(k) than contribute after-tax money to an IRA.
Whether you are a business owner or an individual contributor, financial literacy is important for establishing a budget and an investment plan. Understanding key terms and how they impact your wallet helps ensure that you’re making the most of your hard-earned money.
Sources: Investopedia 1, 2