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The income you earn and the amount that ends up in your paycheck can be very different numbers. This is because your gross income is not equal to your net income.
“Welcome to America. You 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, Pa. . The country’s payroll system involves taxes, insurance premiums, and pension contributions taken first from income, meaning people could bring in far less money than they realize.
“You might say, ‘I’m making $ 100,000, but my checks don’t total $ 100,000,’†says Benjamin Yin, co-founder and director of consulting firm Generational Financial Partners, LLC in Atlanta.
Besides gross income and net income, the terms adjusted gross income and modified adjusted gross income are also frequently used by professionals and financial advisers at tax time. To familiarize yourself with gross income, sources of gross income, and tips for calculating individual gross income versus net income, use this primer.
A person’s employment may be only a portion of a person’s gross income, says 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 can be reported on W-2 forms for employees, 1099 forms for retirees and the self-employed, or K-1 forms for small business owners.
While the proceeds from a garage sale are not considered income, money earned through an eBay business or related activities like driving for Uber should be included. “It’s all your income that comes into play,†says Delfino.
For employees, calculating net income is straightforward. In short, net income is the total income after payroll deductions such as taxes, insurance premiums, and pension contributions. However, this amount is not so obvious to the self-employed who have to add up their self-employment tax, insurance and pension contributions separately. They can also deduct business expenses such as mileage and home office expenses to achieve their bottom line income. However, for both salaried and self-employed people, “net income is the amount of income you can actually spend and enjoy,” Yin explains.
Gross income versus net income
Businesses also have gross and net income, but they can be calculated slightly differently. The gross income of a business is generally the total revenue minus the cost of goods sold. Net income, on the other hand, refers to the net profit of a business, a number that is calculated after deducting all expenses and taxes.
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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. AGI is taxable income and includes a person’s gross income less certain deductions.
“There are many ways to reduce your gross income,†says Delfino. Contributing to a traditional IRA or health savings account is a common way to reduce an AGI. Student loan interest, tuition and tuition fees, and health insurance premiums for the self-employed can also be deducted from gross income to reduce an AGI.
Certain forms of income that are included in a person’s overall gross income may also be excluded from taxable income. For example, qualified distributions from Roth retirement accounts and certain Social Security payments are tax exempt 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 certain deductions added. These include half of self-employment tax, student loan interest, IRA contributions, and rental losses, among other deductions. Many taxpayers do not 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 example, 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, which can lead to buying houses, cars, and other items based on inflated numbers.
“I know it sounds simple and straightforward, but you want to live on your network,†Fried says. And for many people, net income will be significantly less than gross income after taxes and other expenses are deducted.
Tax season is the perfect opportunity to take stock of your sources of income and determine your gross, taxable and net income and use that knowledge to make better decisions on how to save and spend your money. in the coming year.
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