Gross Income vs Net: Key Differences and Examples Explained

Understanding the difference between gross income and net income is essential for managing personal finances, running a business, or evaluating investments. These two figures play a key role in budgeting, tax planning, and financial decision-making, yet they are often confused.

While both terms relate to earnings, what sets them apart is how deductions impact the final amount received.

Gross Income Elements

Gross income includes all earnings before any deductions or taxes. For individuals, this typically consists of wages, salaries, bonuses, and commissions. Employers report these earnings on a W-2 form, and they are subject to federal and state income taxes. Self-employed individuals calculate gross income differently, using total business revenue before subtracting expenses.

Beyond employment earnings, gross income also includes rental income, royalties, and investment profits. Rental income is the total amount received from tenants before deducting property management fees, maintenance costs, or mortgage payments. Royalties, often earned from intellectual property like books, music, or patents, contribute to gross income before any agent fees or production costs are deducted.

Investment income includes interest, dividends, and capital gains. Interest income comes from savings accounts, bonds, or certificates of deposit (CDs), while dividends are payments from stocks or mutual funds. Capital gains arise when an asset, such as real estate or stocks, is sold for more than its purchase price. The IRS requires taxpayers to report these earnings, even if they are reinvested.

Deductions That Affect Net

After gross income is determined, various deductions reduce the total amount an individual or business actually keeps. Payroll taxes, including Social Security and Medicare contributions, are among the most significant reductions. In 2024, the Social Security tax rate is 6.2% on wages up to $168,600, while Medicare tax is 1.45% on all earnings, with an additional 0.9% surtax applied to income exceeding $200,000 for single filers or $250,000 for married couples filing jointly. These taxes are automatically withheld from employee paychecks.

For businesses, operating expenses significantly impact net income. Costs such as rent, utilities, employee salaries, and equipment purchases are deducted from revenue before determining profitability. Depreciation, which spreads the cost of long-term assets over multiple years, further reduces taxable income. The IRS allows businesses to use methods like the Modified Accelerated Cost Recovery System (MACRS) to write off asset values at different rates, affecting financial statements and tax liabilities.

Retirement contributions can also lower taxable income. Employees who contribute to a 401(k) or similar employer-sponsored plan have their contributions deducted pre-tax, reducing the amount subject to income tax. In 2024, individuals can contribute up to $23,000 to a 401(k), with an additional $7,500 allowed for those aged 50 or older. Self-employed individuals may use a Simplified Employee Pension (SEP) IRA or a Solo 401(k), which have higher contribution limits based on earnings.

Health-related deductions further impact net income. Contributions to Health Savings Accounts (HSAs) are tax-deductible, with 2024 limits set at $4,150 for individuals and $8,300 for families. Those with high-deductible health plans can use HSAs to cover medical expenses while reducing taxable income. Similarly, self-employed individuals can deduct health insurance premiums.

State and local taxes, including income and property taxes, also affect net income. The Tax Cuts and Jobs Act (TCJA) capped the deduction for these taxes at $10,000, a limit that remains in place for 2024. This cap disproportionately affects taxpayers in high-tax states like California and New York, where property and state income taxes often exceed this threshold.

Calculation Examples

Understanding how gross and net income differ in real-world scenarios helps clarify their impact on personal and business finances.

Employment

An employee earning a $75,000 annual salary has this amount as gross income before any deductions. If they contribute 5% ($3,750) to a 401(k) and have $5,000 in pre-tax health insurance premiums, their taxable income is reduced to $66,250.

Federal income tax is then applied based on the 2024 tax brackets. If they are a single filer, the first $11,600 is taxed at 10%, the next $35,550 at 12%, and the remaining $19,100 at 22%, resulting in approximately $9,500 in federal taxes. Social Security (6.2%) and Medicare (1.45%) taxes total $5,738. After these deductions, their net income before state taxes is around $51,000.

State income tax varies, with some states like Texas and Florida imposing no tax, while California applies a progressive rate up to 13.3%. If this employee lives in a state with a 5% tax rate, they would owe an additional $3,312, reducing their net income further.

Small Business

A sole proprietor running a consulting business earns $120,000 in revenue. Business expenses, including office rent ($12,000), software subscriptions ($3,000), travel ($5,000), and marketing ($10,000), total $30,000. This leaves a gross profit of $90,000.

Self-employment tax, covering Social Security (12.4%) and Medicare (2.9%), applies to net earnings. The IRS allows a deduction for half of this tax, reducing taxable income. The self-employment tax on $90,000 is $13,770, but the deductible portion ($6,885) lowers taxable income to $83,115.

After applying standard deductions or itemized deductions, federal and state income taxes further reduce net earnings. If the business owner qualifies for the Qualified Business Income (QBI) deduction, they may deduct up to 20% of their business income, lowering taxable income further. Ultimately, after all taxes and deductions, their net income could be around $60,000, depending on their specific tax situation.

Investments

An investor sells stocks for a total of $50,000, having originally purchased them for $30,000. The $20,000 profit is considered a capital gain. If the stocks were held for over a year, they qualify for long-term capital gains tax, which in 2024 is 15% for most taxpayers, resulting in a $3,000 tax liability.

If the investor also earned $5,000 in qualified dividends from stocks, these are taxed at the same preferential rate, adding $750 in taxes. Interest income from bonds or savings accounts, however, is taxed as ordinary income. If they earned $2,000 in interest and fall into the 22% tax bracket, they owe $440 in taxes on this amount.

To offset gains, investors can use tax-loss harvesting, selling underperforming assets to reduce taxable income. If they had $5,000 in losses from another investment, they could deduct this from their capital gains, lowering their tax bill.

Common Misconceptions

One common misunderstanding is equating revenue with profitability. Many assume that a company with high revenue is financially successful, but without considering cost structures, this assumption can be misleading. A business generating $5 million in annual revenue may struggle with profitability if operating expenses, debt obligations, and depreciation significantly reduce net income. Publicly traded companies disclose these details in financial statements, with the income statement distinguishing between gross profit, operating profit, and net income.

Another misconception is that tax refunds indicate financial benefit rather than improper tax withholding. Many individuals view large refunds as a windfall, but in reality, it means they overpaid taxes throughout the year, effectively giving the government an interest-free loan. Adjusting W-4 withholdings to better align with actual tax liability allows taxpayers to retain more income throughout the year rather than waiting for a refund. The IRS provides a Tax Withholding Estimator to help individuals fine-tune withholdings based on income, deductions, and credits.