What is gross income? How it works and why it’s important
What is gross income?
Gross income refers to the total earnings a person receives before paying for taxes and other deductions. The amount that remains after taxes are deducted is called net income. When looking at a pay stub, net income is what’s shown after taxes and deductions. Net income is always lower than gross income unless the person is exempt from paying taxes and has no deductions.
How gross income works
Gross income typically comes from a paycheck, which can comprise a combination of hourly wages, salary, commission and bonuses. But gross income can come from other sources such as annuities, alimony, pension, capital gains, rental income, royalties and income from self-employment. These forms of income are often only partly subject to taxation. Other sources of gross income subject to taxation are:
- Alternative compensation for services rendered
- Business income
- Dividends
- Gambling winnings
- Gas, oil, or mineral rights
- Income from discharged debt
- Income from a decedent or as an interest of an estate or trust
- Interest from bank accounts, certificates of deposit (CDs), etc.
- Selling goods online or in-person
- Tips
Some examples of nontaxable income include inheritance, municipal or state bonds, workers’ compensation payments and life insurance proceeds.
Employers withhold state and federal income taxes, Medicare and Social Security taxes from your paycheck before you receive it. For business owners, self-employed and independent contractors/freelancers, payment is received as gross income and it is their responsibility to pay their share of taxes. A business’s gross income is calculated as gross revenue minus the cost of goods sold (COGS) and may be referred to as gross margin or gross profit margin as a percentage.
Example of gross income
Here is an example of what gross income looks like for an individual on a weekly basis:
- 45 hours worked at $15 per hour = $675
- Commission = $150
- Bonus = $500
- Gross income = $1,325
Here is an example of what gross income might look like on an annual basis:
- Annual salary: $55,000
- Annual bonus: $5,000
- Rental income: $10,000
- Interest: $675
- Stock dividends: $500
- Side business income: $10,000
- Selling goods online: $1,300
- Total annual gross income: $82,475
To determine a business’s annual gross income, here is an example:
- Gross revenue: $250,000
- Cost of goods sold: $200,000
- Total annual gross business income: $50,000
Why understanding gross income is so important
Gross income is what is used by lenders to determine how much they will allow someone to borrow for a loan, like an auto loan or mortgage. The lender will determine how much to lend based on the individual’s debt-to-income ratio, or DTI. The DTI is determined by dividing monthly debt payments by monthly gross income.
The higher someone’s DTI, the less likely a lender will want to loan money and the higher the interest rate on the loan will be. Ideally, DTI should be no higher than 36 percent; however, some lenders will lend as high as 50 percent DTI.
Gross income vs. net income
The total amount of pay received is the gross income, while the net income is the remaining amount after taxes and deductions are removed.
Deductions could include:
- Health insurance premiums
- Life insurance premiums
- Voluntary benefits (accident, sickness, critical injury, disability, etc.)
- Flexible spending account contributions
- Health savings account contributions
- Job-related expenses (uniforms, union dues, meals, travel, etc.)
- Retirement contributions
- Wage garnishments
- Child support payments
Most deductions lower taxable income. These are known as pretax deductions. Other deductions, such as contributions to a Roth IRA and certain voluntary benefits, do not lower taxable income. These are known as post-tax deductions.
Net income is often called take-home pay or disposable income. Net income is what is leftover to spend and can be used to make a budget. Living expenses, bills, debt payments and other obligations should be budgeted out of net income rather than gross income. Making a budget based on gross income will likely cause the budget to be short each month, because the amount required for the budget is reduced by the deductions and taxes taken.
Here’s an example of why a budget should not be based on gross income without accounting for deductions and taxes. Sally has a monthly gross income of $4,000 and a net income of $3,000. She creates a budget with her gross income amount with total expenses equalling $3,500. Because Sally only brings home $3,000, she is short $500 on the monthly budget. Sally will either have to adjust her budget to account for the $500 or find a way to increase her net income by $500 to cover the remaining expenses.
You can sign up for Bankrate’s myMoney tool to categorize your spending transactions, identify ways to cut back and improve your financial health.
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