Are you familiar with the difference between gross and net income? While the concepts of “gross” and “net” income are fairly simple, applying them to your budget can be complicated.
When it comes to creating a functional budget, using net income is generally recommended, since it represents the amount of money you actually have available to spend. In some cases, however, gross income can be a more accurate figure.
What is gross vs.net income?
Gross and net income are both concepts that pertain to the money you earn, but they mean two different things:
- Gross income: The total amount you earn, before any taxes or deductions. In most cases this is your income from an employer, and it’s equivalent to your salary.
- Net income: Also referred to as “take-home pay,” net income is the amount you’re paid after taxes and all other deductions are withheld.
When you look at your pay stub, you can see information about both your gross and your net income. While your gross income is the larger figure that your employer pays out, some of that money will not end up in your wallet or bank account.
Some of the money that’s withheld from your gross income covers things like estimated income taxes, while other deductions are voluntary and can be changed upon your request, such as your contribution to your 401(k). Whatever amount is withheld, the remainder is your net income.
Which income figure should you use for budgeting?
When you make a household budget, net income is often the best figure to use. That’s because net income represents the amount of money you have available to spend from each paycheck. If you use gross income instead, you might end up spending money that’s already been allocated elsewhere.
But gross income can be a more accurate figure if you use a budgeting tool that calls for it. If you do need to list your gross income, just make sure to add taxes and deductions as separate line-item expenses.
Why It Matters
You can throw your budget out of whack if you choose the wrong version of income for the budget tool you use, or if you’re not consistent about the numbers.
For example, if you use net income but then list your payroll deductions as separate expenses, you’ll end up counting those expenses twice.
That might seem like a small mistake, but it can cause big problems, especially if there’s a significant difference between your gross and net income… which is the case for most people. According to a report from GoBankingRates on differences in gross and net salary by state, people who earn $50,000 (gross) take home an average of $38,942 to $34,290 (net) per year. That’s a difference of up to $15,710 a year, or $1,309 a month.
Other common budgeting pitfalls
There are a few common pitfalls you can make when it comes to your income and budgeting. Keeping them in mind can deepen your understanding of your finances and help you follow an accurate budget.
Double-counting expenses
If you use gross income for your budget, you’ll need to add your deductions as line-item expenses. If you use net, however, it’s incorrect to include your deductions as expenses, since they’re already covered by your paycheck.
Here are some common payroll deductions to keep in mind when creating your budget:
- Taxes
- Healthcare premiums
- Retirement plan contributions
- Health Savings Accounts (HSAs)
- Wage garnishments
If you use net income for your budget, don’t add your deductions into your budget, but consider tracking them separately instead.
Forgetting about taxes
Tax bills and tax refunds typically affect your budget just once a year, so it’s easy to forget about them when. One way to fix this oversight is to divide your average return or bill by 12, and then add the figure to your monthly budget.
Alternatively, if you get a large refund each year, you may want to exclude it from your spending budget and plan to put the money toward a financial goal, like paying off credit cards.
Just remember that a large refund is often an indication that your employer is withholding too much each paycheck. You can change your withholding by working with your employer’s HR or payroll representative.
Calculating pay periods incorrectly
Many people are paid bi-weekly, or every two weeks. If you’re in this group, you receive 26 paychecks per year, not 24, so it’s common to miscalculate your income. Instead of calculating your monthly income by multiplying your average paycheck by two, you’ll need to use this formula instead:
Monthly income = (Average pay per period x 26 paychecks per year) / 12 months in the year
For example, if you earn $2,000 per pay period, the calculation will look like this:
Step 1: Monthly income = ($2,000 x 26) / 12
Step 2: Monthly income = $52,000 / 12
Step 3: Monthly income = $4,333
If you’re not sure how to calculate your income or expenses correctly, a certified credit counselor can help.
Applying budgeting guidelines
Have you heard the “rule” that you should spend no more than 30% of your income on housing? Or that transportation expenses should account for less than 10% of your monthly income?
These guidelines, and others like them, can be helpful for gauging your financial well-being. However, before you apply them, you should know whether they’re based on net or gross income. In the examples above, the housing guideline uses net income while the transportation guideline uses gross.