The income you earn and the amount that ends up in your paycheck can be very different figures. That’s because your gross income is not equal to your net income.
“Welcome to America. You’d better understand how the (payroll) system works,” says Mark Fried, author of “Road Rules to Retirement: Set Your Destination Enjoy the Journey” and president of TFG Wealth Management in Newtown, Pennsylvania. The country’s payroll system involves taxes, insurance premiums and retirement contributions coming out of earnings first, which means people could be bringing home significantly less money than they realize.
“You might say: ‘I make $100,000, but my checks don’t add up to $100,000,'” says Benjamin Yin, co-founder and principal of advisory firm Generational Financial Partners, LLC in Atlanta.
Along with gross income and net income, the terms adjusted gross income and modified adjusted gross income are also frequently used by professionals and financial advisors at tax time. To brush up on what gross income is, sources of gross income and tips for calculating individual gross income versus net income, use this primer.
What Is Gross Income?
A person’s employment may be only one part of a person’s gross income, explains Dave Delfino, financial advisor at wealth management firm Essex Financial in Essex, Connecticut. Gross income can also include alimony, interest, dividends, withdrawals from retirement funds, rental income and Social Security. It may be reported on W-2 forms for salaried employees, 1099 forms for retirees and self-employed workers or K-1 forms for small business owners.
While proceeds from a garage sale may not be considered income, money earned from an eBay business or side hustles like driving for Uber should be included. “It’s all your income coming in,” Delfino says.
What Is Net Income?
For wage earners, calculating net income is simple. In short, net income is the total income after payroll deductions such as taxes, insurance premiums and retirement contributions. However, that amount isn’t so obvious for self-employed workers who have to add up their self-employment tax, insurance and retirement contributions separately. They may also deduct business costs such as mileage and home office expenses to reach their net income. However, for both the employed and the self-employed, “net income is the amount of income you get to actually spend and enjoy,” Yin says.
[See: 15 Tax Questions — Answered.]
Gross Income Versus Net Income
Businesses also have gross and net incomes, but they may be calculated in a slightly different way. A company’s gross income is typically the total revenues minus the cost of the goods sold. Net income, on the other hand, refers to a company’s net profit, a number that is calculated after all expenses and taxes have been deducted.
How to Calculate Your Adjusted Gross Income
During tax time, a person’s adjusted gross income and modified adjusted gross income, or AGI and MAGI, respectively, become important. The AGI is taxable income and includes a person’s gross income minus certain deductions.
“There are many different ways you can chip away at your gross income,” Delfino says. Contributing to a traditional IRA or health savings account is a common way to reduce an AGI. Student loan interest, college tuition and fees and health insurance premiums for self-employed workers can also be deducted from gross income to reduce an AGI.
Some forms of income that are included in a person’s overall gross income may also be excluded from taxable income. For instance, qualified distributions from Roth retirement accounts and some Social Security payments are exempt from taxes and therefore not part of an AGI.
How to Calculate Your Modified Adjusted Gross Income
A modified adjusted gross income is equal to the adjusted gross income with some deductions added back in. These include one-half of self-employment tax, student loan interest, IRA contributions and rental losses, among other deductions. Many taxpayers don’t qualify for these deductions, so their AGI and MAGI will be the same.
Determining your modified adjusted gross income is important because it is used to determine whether a taxpayer qualifies for certain deductions. For instance, the ability to deduct IRA contributions and student loan interest is tied to modified adjusted gross income.
How to Factor Gross Income Into Your Budget
Being able to distinguish between gross income and net income is crucial for financial stability. Many people make the mistake of using their gross income to make spending decisions, and that can lead to purchasing homes, cars and other items based on an inflated number.
“I know it sounds simple and straightforward, but you want to live on your net,” Fried says. And for many people, net income will be significantly lower than gross income once taxes and other expenses are deducted.
Tax time is the perfect opportunity to take stock of your sources of income and determine your gross, taxable and net income and use this knowledge to make better decisions about how to save and spend your dollars in the year to come.
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