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One of the first steps to understanding your finances is understanding your income. Once you know what you bring in each month — and can predict this at least somewhat reliably — you’ll be able to create a budget.
Gross income vs. net income
Gross income is the money you make before taxes and deductions. Net income, also called "take-home income," is the money that actually goes into your bank account.
Most people receive their income from either an hourly wage or a salary. We'll assume for now you're getting paid as a regular employee, not as an independent contractor, whose income will look a bit different.
Gross income is pretty easy to figure out. If you’re an hourly wage earner, your weekly gross income is the number of hours you work in a week multiplied by your hourly rate. If you’re working at the federal minimum wage of $7.25 and you work 40 hours in a week, your weekly gross income is $290. Your monthly gross income would be roughly $1,160.
If you’re a salaried employee, your monthly gross income is your yearly salary divided by 12. If your annual salary is $36,000, your monthly gross income would be $3,000.
Depending on how often you’re paid and where your payday lands in the month, these numbers might change slightly from paycheck to paycheck. You’ll want to make sure your gross income lines up with the wages or salary you were promised. All the numbers we’re discussing in this article should be listed on your pay stub, the receipt that comes with your paycheck.
Now, the really important question is, where did all your money go between your gross income and your actual take-home pay?
The answer: taxes, called withholding, and deductions.
Withholding is basically an estimate of what you’ll owe in taxes annually, regularly taken out of your paycheck throughout the year. This is so you don’t find yourself with a surprisingly large bill, or ”liability,” come tax season.
Instead, an estimate of your taxes was already paid to the government. When you do your annual tax return in April, the government compares the taxes already withheld from you with the taxes you actually owe. If it turns out you owe less than what's been withheld from you, you get a tax refund. If you owe more than what's been withheld, you’ll need to cut a check to the IRS.
When you get a new job, your employer should have you fill out a W-4 form. You’ll want to fill out this form accurately so that your tax withholding estimate is as close to your actual tax liability as possible. The IRS has a tax withholding calculator here.
Beyond federal income tax, you might see money withheld for your state or municipal income tax as well, depending on where you live.
You’ll also have deductions removed from your paycheck for Social Security and Medicare taxes, any employer-sponsored insurance contributions and any contributions into an employer-sponsored retirement account, like a 401(k).
You might also find information on your pay stub about other types of pay like overtime, holiday and sick pay.
What about independent contractors?
Some workers don't meet the IRS definition of "employee" and are instead paid as independent contractors. An independent contractor won't fill out a W-4 form when they start a new job and will receive a 1099 form come tax season. If you make your livelihood as an independent contractor, you're self-employed and are responsible for paying income taxes and deductions on your own. That means no tax withheld for you throughout the year and a higher Social Security tax (employers usually pay a portion of it).
Since no tax is withheld, you'll generally have to pay an estimated tax quarterly to the IRS in addition to filing an annual tax return. The checks you receive for work are your gross income; it's up to you to calculate your take-home pay. Don't make the mistake of spending money before you've paid taxes on it.
From income to budgeting
So now you know why the net pay printed on your check differs from your gross income. This after-tax take-home income is the number you’ll need to start budgeting, but you’ll want to add back in any savings and insurance contributions that were automatically deducted. These automatic contributions are part of your budget, and you’ll want the ability to break them out of your total take home income into different budgeting categories.
There are many other types of income beyond just wages and salaries, but these are the basics to get you started.
Stephen Layton is a staff writer at NerdWallet, a personal finance website. Email: [email protected].