By Debra Donston-Miller | American Express Credit Intel Freelance Contributor
4 Min Read | December 15, 2021 in Money
Your net income is the amount of money you actually have the option to spend. In contrast, gross income is all of the money you earn.
Net income is calculated by subtracting taxes, pretax deductions, health insurance payments, and other payments from your gross income.
Net income is not reported on tax forms, but ensuring that the correct amount of taxes is withheld helps make your net income more accurate.
There are many different types of income, with many different labels. But net income might be one of the most important to you and me. Why? Because it’s the amount of income you actually get to spend on the things you need and want, from paying the rent or mortgage to your credit card statement, buying food, funding your child’s college education, saving for retirement – “little” things like that.
So, what does net income mean? Well, if gross income is all of the money you actually earned, then net income is the money you can actually use. Usually, it’s the same amount as your take-home pay.
In general, income is the money you earn on a regular basis. This could include – but is not limited to – salary, bonuses, tips, hourly wages, rental income, dividends from stocks and bonds, and savings account interest. In the less traditional but growing “gig” economy, people earn money from multiple part-time, temporary, or freelance positions.
You may earn money from one, several, or all of these sources, but all of those earnings you receive count toward what is known as your gross income. Gross income, however, is not what goes in your pocket. Rather, net income is what’s left over – the amount of money you can spend or invest – after you subtract your income withholding taxes and other unavoidable deductions from your gross income.
Don’t be confused by the fact that businesses also have net income. For them, net income is not the only money they can spend. Instead, it’s roughly equivalent to their profit after expenses, though not always an exact match.
It’s important to know your net income because it’s used for many purposes that may matter to you, including the following three examples.
Creating a budget: Your net income is the actual amount of money you have to spend. To manage it wisely, it’s considered a best practice to create a monthly budget. After you add up all of the money required to pay bills and other expenses, you can determine how much of your net income is left over to save or to spend on other things.
Planning for the future: Knowing your net income and how much of it is available after expenses will help you plan for your short- and long-term financial future. This includes not only the money you can allocate to things like investments, college funds, and retirement savings, but also the money you can spend on nonessentials, such as vacations.
Taxes: While net income is not reported on individual tax forms, there is an important relationship between net income and taxes. It may feel good to get a refund at tax time, but refunds mean that throughout the year you’ve had less net income to invest or spend. On the flip side, if you owe money at tax time you’ve essentially been spending or investing more net income than you actually have. If either is the case, you can revise your W-4 form to better manage how much your employer withholds in income taxes. For freelancers and other members of the gig economy, it’s important to pay enough in estimated taxes during the year to ensure that you’re not over- or underestimating your true net income.
Calculating your net income is fairly straightforward: Start with your gross income, then subtract expenses such as federal and state income tax, Social Security tax, pretax deductions such as 401(k) contributions, and health insurance payments.
For example, say your monthly gross income is $5,000. You pay $600 per month in federal and state taxes, $200 per month toward your 401(k), $200 per month for health insurance, and $100 per month for Medicare. Your monthly net income could be calculated as follows: $5,000 - ($600 + $200 + $200 + $100) = $3,900.
If your monthly income and expenses are regular, multiply your monthly net income by 12 to determine your net income for the year: $3,900 x 12 = $46,800.
The material made available for you on this website, Credit Intel, is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.