Gross Income: What Is It And Why Is It Important?
To the untrained ear, gross income may sound off-putting. No, it’s not some shady side hustle; it’s a financial term that defines your total income before deductions. When budgeting for life expenses, it’s essential to know your total income for the month or year. Understanding what your gross annual income is, and how it relates to your net income, will make your financial life easier to navigate.
What Is Gross Income?
Gross income is the total amount of earnings a person or a business makes before subtracting taxes and other expenses. Your gross income is the starting point when filing your tax returns. Gross annual income accounts for these earnings in a year.
The term “gross income” is used interchangeably with “gross pay.” For businesses, the terms “gross margin” and “gross profit” are also used. Each of these terms refers to the total amount of money made in a year before deductions like taxes and operating costs.
Sources Of Gross Income
When calculating gross income, you need to include all sources. Most people receive income from at least one of the following:
- Wages and salary from a W-2 job, as well as secondary or freelance jobs
- Tips received at your place of employment
- Items sold online, or at a fair or venue, even as a hobby
- Rental property income
- Any interest, dividends, and capital gains earned from investments
- Received alimony payments
- Pension payments
- Unemployment earnings
What do all these forms of income have in common? They’re taxable. You’re legally required to report them on your Form 1040 when filing your tax return.
Why Is Gross Annual Income Important?
Gross income is important to your financial success. If you’re looking to apply for a mortgage, your gross income is key to knowing how much you can afford. Mortgage lenders and landlords use your gross income to determine your financial reliability. Lenders want to know what percentage of your income will go to a mortgage payment.
Since each person has a different list of deductions, gross income is a level starting point for understanding finances.
Gross Vs. Net Income
If your gross income is a total of all your income, then your net income is what you’re left with once all the deductions are taken out. A simple mnemonic device for remembering the difference between gross and net income is this: net is what’s in your net. It’s what you get to take home with you. Your net income – or “net pay” or “take-home pay” – is the money left over after the following is taken out of your paycheck:
- Income tax
- Social Security tax
- Health insurance and health savings account (HSA) contributions
- IRA, 401(k), or retirement fund contributions
- Any necessary legal payments (e.g. loan or mortgage repayments, child support or alimony, etc.)
This is simple to understand on a personal level, but let’s take it a step further. Net income for businesses means something slightly different because there are more expenses involved. When talking about net income for businesses, it’s also referred to as “net profit.” As gross income is the total revenue minus the cost of goods sold, net income is the money left over after everything else has been paid. Employee salaries and benefits, taxes, travel expenses, marketing and operating expenses all subtract from the bottom line, leaving you with net profit.
What Is Adjusted Gross Income?
Adjust Gross Income (AGI) is a calculation taken from your gross income to determine the amount that is taxable. Essentially, your AGI is your gross income minus adjustments that the IRS allows. If you’ve ever heard of tax deductions, this is in reference to your AGI. There are several common deductions:
- Moving expenses due to relocating for a job, business, or military
- Student loan interest or tuition fees
- Certain expenses for those who are self-employed
- Alimony paid
- Health Savings Account (HSA) deductions
- Tuition and education fees
As you can see, it’s an important part of filing your taxes. If you itemize your deductions, it will lower your AGI, which lowers your taxable income. Accurately reporting your AGI on the IRS Form 1040 determines your eligibility for claims on your tax return. The more claims you’re eligible for, the more money you’ll receive on your return.
What Is Modified Adjusted Gross Income?
Modified Adjusted Gross Income (MAGI) is another part of your finances that is important to know. Your MAGI determines whether you can contribute to a Roth IRA or deduct your regular IRA contributions from your taxes, along with your eligibility for the premium tax credit.
To calculate you MAGI, take your AGI and add back the following deductions:
- Specific tax exemptions (e.g. homestead, disability, senior, or veteran)
- Retirement fund and Social Security contributions
- Student loan interest or tuition
- Excluded foreign income
- Rental and other passive income or losses
It’s normal for your AGI and MAGI to be close in amount. While you can always contribute to a traditional IRA, if your MAGI exceeds the IRS’ limits, you won’t be able to deduct these contributions on your taxes. To qualify for the premium tax credit, your MAGI must fall between 100 – 400% of the federal poverty line. Just like with your Adjusted Gross Income, figuring out your MAGI could mean more money back on your tax return.
The Bottom Line
Don’t let financial terminology confuse or intimidate you. Knowing your finances and how they’re defined is important. Your gross income is every piece of your income, where your net income is what you take home with you. Gross income is used by lenders and landlords to determine what you can afford. Understanding your gross income and how to calculate your adjusted gross income and modified adjusted gross income can lead to savings on your taxes.
With any questions or uncertainties you have about your finances or taxes, you should bring them to a financial advisor or tax professional. It’s important to stay informed about your own finances, but also know when you need with help with them. A financial advisor or tax professional will help you make the most of your income. That’s something everyone can get behind.