Understanding the difference between gross income and net income is important when it comes to evaluating your financial status on a personal level or how your business is doing if you are a business owner. It can also impact your understanding of how to account for paying taxes. Because gross income is used to calculate net income, these terms are easy to confuse.
Gross vs Net Income
Gross income and net income can provide a different perspective and affect goals and actions you may take personally or as a business owner. As a business, gross income can indicate the revenue generated year over year and give a perspective on how your business is doing. However, net income will tell you a slightly different picture – how much you are making after expenses are factored into the equation. If your net income is lower than expected, consider cutting some expenses.
For individuals, net income means less than it does for businesses. When completing a Form 1040 for the IRS, an individual will need to calculate their adjusted gross income (AGI). AGI is gross income minus adjustments to income which shows the amount of taxable income an individual has.
What is gross income?
Gross income is the total amount you earn (typically over the course of a year) before expenses. Think of it as the profit you’ve made from the services you provide—the sum of all your client billings before any deductions, taxes, or withholding.
How is annual gross income calculated?
If your client billings from the past year added up to $90,000 in revenue, that number is your annual gross income or total gross wages.
How your gross income affects your goals
Gross income is a helpful way to look at the revenue potential of your business and to assess how you are doing year over year. By looking at your various revenue streams, you can see which clients and which types of projects bring in the most income and the least income. This insight may influence where you choose to direct the majority of your time and effort, or determine the future goals you set for your business.
What is net income and what does net income mean?
Net income is the profit your business earns after expenses and allowable deductions.
How is annual net income calculated?
To calculate net income, take your gross income and subtract all of your business expenses—marketing or advertising costs, travel or office expenses, tax payments, etc.—as well as any deductions you may be eligible for such as a home office space, retirement plan, or legal and professional fees. For example, if your business expenses for the year totaled $30,000, your annual net income would be $60,000 – ($90,000 – $30,000).
How your net income affects your goals
Net income can also help you understand the health of your business. For instance, if your gross income is significantly higher than your net income year after year, you may want to evaluate your expenses line-by-line to see what you can eliminate or reevaluate.
Why knowing the difference is important
Knowing your gross and net income is an important part of managing your finances on a personal level and managing a successful business if you are a small business owner or self-employed. It can also help you make important decisions about income choices, such as when to raise your rates, whether or not certain expenses are necessary, and the types of income, projects and clients that you should be focusing on.
To learn how to calculate your income based on expenses and allowable deductions, try our calculator.