Creating a budget doesn’t need to be complicated, but there are a few common pitfalls you’ll want to sidestep. One of the biggest mistakes people make is confusing their gross income with their net income.
Although these terms might sound similar, they’re actually quite different. Using your gross income to map out your budget might lead to unwittingly spending money you don’t actually have. Fortunately, this budgeting blunder is pretty simple to correct.
Gross and net income describe two different ways of looking at your earnings. Here’s how they differ:
Gross income refers to the salary or wages you earn before any deductions, like taxes and benefits, are taken out. Often called your pre-tax pay, it’s typically the largest figure on your paycheck.
Net income, on the other hand, is what you take home after taxes and other deductions. This is the amount you have available to spend or save, and it’s usually smaller than your gross income.
A lot of folks feel frustrated when they see how much less their net income is compared to their gross income. Why does so much get docked from your paycheck? Well, for starters, your employer deducts payroll and income taxes. You might also reside in a state with high income taxes, such as California, Hawaii, or Oregon. Plus, deductions for benefits like 401(k) contributions and health insurance premiums typically reduce your gross pay even further.
Always check your pay stub to understand what’s being withheld. You’ll see details like:
Basing your budget on gross income is a mistake waiting to happen. When you do this, you’re inadvertently planning to spend funds that are already allocated elsewhere. To dodge this trap, always factor in your net income when budgeting and exclude items deducted from your paycheck. For instance, contributions to employer-sponsored retirement plans like a 401(k) shouldn’t be listed as a budget expense.
For most, crafting a budget around your average monthly net income is the way to go. This method helps you avoid recalculating your budget every time there’s a change in your income while ensuring that you can consistently meet your regular monthly expenses.
However, many skip a few steps when figuring out their average monthly net income. To do this accurately:
1. Check your net income from your last three paychecks.
2. Calculate your average monthly income. This is straightforward if you’re paid monthly but requires a bit of calculation if you’re paid weekly or biweekly. Here’s how to get that average:
For biweekly pay:
Monthly net income = (Average paycheck x 26 pay periods in a year) / 12 months
Example: ($3,000 average paycheck x 26) / 12 = $6,500 per month
For weekly pay:
Monthly net income = (Average paycheck x 52 weeks in a year) / 12 months
Example: ($1,200 average paycheck x 52) / 12 = $5,200 per month
If your earnings fluctuate—perhaps due to seasonal work or extra shifts—estimating a useful figure can be tricky. Fortunately, there are tactics to help you gauge your net income and stick to a budget:
Tax returns can offer insights, especially if your income varies similarly each year. Refer to the net pay averages from the last couple of years.
Be conservative if future earnings are uncertain. Reflect on what you earn during a lean month to ensure your lowest income covers essential expenses.
Focus on monthly expenses so you’re prepared if your income falls short.
Save more during high-earning months to tide over lean periods.
To boost your net income, you might consider reducing voluntary deductions like retirement contributions or even relocating to a state with no income tax, such as Florida, Nevada, or Texas. However, remember that changing deductions could increase your annual tax bill.
Wondering where to find your net and gross income? Check your pay stub. The gross income is typically at the top and is the largest earnings figure shown. The net amount is often labeled as “take-home pay” or “net pay.”
A dip in your net income might arise from several sources, such as high tax deductions or hefty retirement contributions. To uncover specifics, review your pay stub, or consult someone in payroll or HR for clarity.
