Are you familiar with the difference between gross and net income? If so, which one should you use when you are budgeting for major purchases? As it turns out, the concepts of “gross” and “net” incomes are very simple, but the implementation can be a bit more complicated. In this post we will give you a quick refresher about the differences between the two terms and how you can use them when budgeting.
Gross vs. Net Income Explained
One quick note: we are focused exclusively on these terms in the context of personal finance. While the concepts are certainly very similar across other contexts, like business usage, just remember that we are talking about your personal income.
Your gross income is the total amount you are paid before any deductions. In most cases this will be income from your employer. It is the equivalent of your salary. If you take a job position that pays $40,000 per year, then your gross income will be $40,000. Now, if you have multiple sources of income—say a full-time job paying $40,000 and a part-time job paying $10,000—then your gross income would include the second source. You would therefore have a gross income of $50,000.
Your net income is your gross income minus deductions. It is also referred to as your take-home pay. The simplest example is when your employer withholds taxes from your paycheck. Your gross income is reduced by your withheld tax amount, and what remains is your net income. In addition to tax withholdings, your employer may also withhold funds for retirement contributions, health insurance premiums, or other benefits. Whatever is withheld, the remainder is your net income.
Which Income Figure Should You Use for Budgeting?
When you are making a budget, you will want to determine whether to use your gross or net income in your planning. This will vary depending on which budgeting tool you use. Some may instruct you to list your gross income, and then taxes and deductions will be line items as expenses. Others may ask you to start with your net pay. If you start with your net pay, you will just need to ensure that you don’t double count an expense in your budget (like health insurance premiums) that may have already been deducted from your pay.
Deciding which income figure to use is a relatively minor detail when it comes to general, monthly budgeting because your budget tool will guide you, or if you budget by hand you can figure out which way is preferable to you.
However, it can be a very important detail when you are budgeting for specific large purchases. Just to give a few quick examples—have you heard the “rule” that you should spend 30 percent or less of your income on housing? Or that transportation costs should account for less than 10 percent of your monthly income?
These guidelines and others like them can be very helpful for thinking about your financial well-being and making plans for your future. However, before you ever complete a purchase using one of these principles, you should know whether you are making calculations based on net or gross income.
In the links above, the guideline about housing costs uses net income. Meanwhile, the tip about transportation costs uses gross income.
Why It Matters
GoBankingRates has published a list of how much the average resident in all 50 states would take home as net income based on a $50,000 salary (gross income). According to that post, in California someone with a $50,000 salary would net $38,697. When divided by 12, that comes out to $3,224.75 per month.
Following the housing rule above, that leaves a housing budget of about $967 per month (30 percent of $3,224.75). Had you used gross income for the calculation, you would have arrived at a housing budget of about $1,250 per month. This is a huge difference, as for some people a rent of $1,250 would not be affordable.
This is just one simple example, but you can probably see how the distinction between net and gross income can a make a very big difference in whether a course of action will be a good financial move or not. If you use gross income in your calculation when you should have used net, you may end up on a path that is not financially sustainable.
Other Common Pitfalls
While we are already on the subject of gross vs. net income, here are a few minor “pitfalls” related to these two types of income. Keeping these in mind will deepen your financial understanding and help you keep a predictable budget.
Don’t Double Count Expenses
We mentioned this briefly before. If you use a budgeting tool that asks you to start with net income, be sure that you have a way of tracking your deductions. For example, let’s say that you have retirement contributions taken out of your paycheck each month. If you make a budget based on net income, then your starting point will be after the retirement savings have already come out.
When you get to the line item for “retirement” on your budget, you would need to exclude the amount already deducted from your check. This might mean putting zero dollars, or listing other retirement savings you made outside of your paycheck. You wouldn’t want to count an expense twice because that would throw off your whole budget.
Also important—you will want to keep your deductions in mind and not forget about them. There may be some optimizations and improvements you could make to your deductions and if they are totally out of sight and mind you might not think about them very often.
This is somewhat related to the point above, but don’t forget about your taxes. If you get a large refund each year, then in a way that means your net income is higher than your paychecks indicate, because you are essentially having too much withheld throughout the year. You can change your withholding by working with HR at your employer to do so. Or, you may prefer having a large refund, which can operate in some ways like a zero-interest savings account. Either way, remember that tax withholdings will affect your net pay.