What is gross income? How it works and why it matters
What is gross income?
Gross income is the total amount of compensation a person receives on their paycheck before any deductions or taxes are taken. When you look at a paycheck stub, net income is what is shown after taxes and deductions. Net income is always less than the amount of gross income, unless there is no deduction and the person is exempt from tax. Gross income can also be referred to as pre-tax or pre-tax income.
How gross income works
Gross income usually comes from a paycheck, but it can also come from other sources. A paycheck can be a combination of hourly wage, salary, commission, and bonuses.
The other sources of gross income are:
- Alternative remuneration for services rendered
- Business income
- Capital gains
- Game wins
- Rights on gas, oil or minerals
- Income from paid-up debt
- Income from a deceased person or as interest from an estate or trust
- Interest on bank accounts, certificates of deposit (CDs), etc.
- Rental income
- Royalty fee
- Self-employment / self-employment
- Sell ââmerchandise online or in person
All of these examples are considered to be part of gross income and are often only partially taxable. Some examples of tax-free income include inheritances, municipal or state bonds, workers’ compensation benefits, and life insurance products.
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, the payment is seen as gross income and they are responsible for paying their share of taxes. The gross income of a business is calculated as gross income minus cost of goods sold (COGS) and can be referred to as gross margin or gross profit margin as a percentage.
Example of gross income
Here is an example of what an individual’s gross income looks like on a weekly basis:
- 45 hours worked at $ 15 an hour = $ 675
- Commission = $ 150
- Bonus = $ 500
- Gross income = $ 1,325
Here’s 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
- Secondary business income: $ 10,000
- Sale of goods online: $ 1,300
- Total annual gross income: $ 82,475
To determine the gross annual income of a business, here is an example:
- Gross income: $ 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, such as a car loan or mortgage. The lender will determine the amount to lend based on the individual’s debt-to-income ratio, or DTI. The DTI is determined by dividing the monthly debt payments by the monthly gross income.
The higher a person’s DTI, the less likely a lender is to want to lend money and the higher the loan interest rate will be. Ideally, the DTI should not exceed 36%; however, some lenders will lend up to 50 percent of the DTI.
Gross income vs net income
The total amount of remuneration received is gross income, while net income is the amount remaining after deducting taxes and deductions.
Deductions can include:
- Health insurance premiums
- Life insurance premiums
- Voluntary benefits (accident, illness, serious injury, disability, etc.)
- Flexible contributions to the expense account
- Health savings account contributions
- Employment expenses (uniforms, union dues, meals, travel, etc.)
- Pension contributions
- Wage garnishments
- Child support payments
Most deductions reduce taxable income. These are called pre-tax deductions. Other deductions, such as contributions to a Roth IRA and certain voluntary benefits, do not reduce taxable income. This is called after-tax deductions.
Net income is often referred to as take home pay or disposable income. Net income is what is left to spend and can be used for budgeting. Living expenses, bills, debt payments and other obligations should be budgeted from net income rather than gross income. Budgeting based on gross income will likely result in a reduced budget each month, as the amount required for the budget is reduced by deductions and taxes levied.
Here’s an example of why a budget shouldn’t be based on gross income without factoring in deductions and taxes. Sally has a gross monthly income of $ 4,000 and a net income of $ 3,000. She creates a budget with the amount of her gross income with total expenses equal to $ 3,500. Because Sally only brings home $ 3,000, she is missing $ 500 from the monthly budget. Sally will either have to adjust her budget to accommodate the $ 500 or find a way to increase her net income by $ 500 to cover the remaining expenses.
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