Gross vs Net Income Explained

What’s the difference between the two and why does it matter?

Gross income is the amount of income your employer and the government say you earn. Net income is the amount of money you get in your paycheck. Government programs and lenders make decisions based on your gross income. You get to spend your net income.

Differentiating gross income from net income can seem a simple concept, but most people don’t even bother to figure out the difference. When making the largest decisions of their lives, they base their calculations on the wrong income. Let’s go into more details about each and why it matters.

Gross Income

Most employees can tell you exactly how much gross income they earn. They agree to it when hired. They get updates about it during annual reviews. They see it on their W-2s each tax season. They may even share it with select family and friends during casual conversations. Gross income creates strong emotions. It can seem like a lot of money, so it can generate feelings of security for large gross incomes or, conversely, fear for insufficient gross income levels.

What Is Gross Income?

When you think about it, your gross income is a fantasy. It does not exist. Granted, your employer lures you into your job by promising you a certain level of gross income, but you don’t get to spend it.

Your gross income is the amount your employer agrees to pay, not just to you, but to you, the IRS, your retirement plan, and your health insurance provider.

Other Names for Gross Income

You will hear gross income referred to by many names. Other than gross income, you will most commonly hear the terms pre-tax income, earned income, salary (e.g. annual or monthly), and annual pay.

Who Bases Decisions on Your Gross Income?

• IRS

• State and local tax commissions

• Company benefits

• Prospective lenders

• Retirement plans

• Some government assistance programs (e.g. SNAP, TANF)

• Other government programs with eligibility based on area median income or AMI, such as public housing agency rental assistance.

The two most common uses of uses for your gross income involve taxes and benefits. You and your employer must report some amount of income to the government for the IRS and state and local tax collection agencies to determine your share of income tax to pay.

Lenders also use your gross income in their loan application processes. When a prospective lender asks a borrower to list income, the lender typically wants to see the individual’s or household’s gross income or annual salary. Their loan calculations then subtract typical expenses to estimate an expected net income. Unfortunately, such calculations do not account for the expenses and bills of each household, leading to overborrowing by individuals and couples who have higher-than-expected monthly bills.

Congress has, from time to time, passed laws that allow you to use your gross income to pay for certain benefits, which means you don’t have to pay taxes on the amount you spend on these products and services. Most commonly, these include your health insurance premium and your contributions to a 401(k), 403(b), Thrift Savings Plan, and traditional Individual Retirement Accounts.

Government assistance programs such as SNAP (Supplemental Nutrition Assistance Program) qualify households for “food stamps” based on gross income. Other government programs use your “adjusted gross income” or your “modified adjusted gross income” to determine your eligibility for Medicaid or for contributing to a Roth IRA. However, both adjusted gross incomes could better be termed government-defined net incomes.

Any program that refers to the federal poverty level will use your gross income when determining if and where you fall on the poverty scale. This typically includes programs such as Temporary Assistance for Needy Families (TANF).

Public housing agencies that administer housing vouchers consider your gross income and compare it to the area’s median income (AMI) as part of their eligibility process.

Net Income

While it might feel good to think about having a big gross income, your net income should matter much more to you. Your net income makes it possible to take care of your living expenses and fund your lifestyle.

What Is Net Income?

Net income is your gross income minus the taxes you pay and minus your pre-tax health insurance premiums and your contributions to retirement plans such as a 401(k), 403(b), Thrift Savings Plan, and traditional IRAs. In essence, your net income is the money you use to make purchases and pay bills.

Other Names for Net Income

The term Net Income might confuse some consumers because businesses also use it to describe their profitability.

On a personal and household level, you might hear other terms for net income such as your pay, your paycheck, your take-home pay, your taxable income, your adjusted gross income, and your modified adjusted gross income. Terms that include “adjusted” or “tax” actually refer to income calculations found on our end-of-year tax forms and don’t necessarily equate to your net income.

Who Bases Decisions on Your Net Income?

• Consumers (for household spending plans)

• Any government program based on adjusted gross income or AGI (e.g. Medicaid, SSI, COVID-19 stimulus checks)

First and foremost, you use your net income. You spend it, and you pay bills with it. You should also use your net income as the basis for any household budget you put together and use.

“Government programs that rely on adjusted gross income, such as Medicaid in many if not all states, may just be using your net income under another name.”

Less commonly, government programs during times of economic emergencies, such as the COVID-19 pandemic, consider a household’s AGI before providing assistance like the stimulus checks that went out to taxpayers in 2020.

Other Income

Besides gross and net income, you might hear terms like countable income or qualifying income. These terms often refer to program eligibility requirements rather than to your gross or net income.

For example, when considering a household’s eligibility for supplemental security income (SSI), the Social Security Administration computes the individual’s countable income before determining how much SSI to provide each month. Countable income works differently from both net income and gross income. Countable income starts with gross income and subtracts a set dollar amount and then divides the remaining balance by two. Countable income is more an accounting term to set a benefits level rather than a description of your earned income.

Related Questions

Why is it important to use your net income instead of your gross income when budgeting?

You never even get to see in your checking account the difference between your gross and net incomes, let alone get to spend it. Since you never receive the amount of your paycheck that goes to paying taxes, insurance, and benefits, you should base your budget on the money you can spend.

How do you calculate your annual net income?

To calculate your annual net income, multiply your average paycheck by the number of paychecks you receive in a year. If you get paid twice a month, multiply your paycheck by 24. If you get paid every two weeks, multiply your paycheck by 26.