The Difference Between Net and Gross Pay: A Beginner’s Guide to Calculating Your Paycheck 

gross pay vs net pay

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When it comes gross pay to our paychecks, many of us often focus only on net pay whether we know it or not. This is the amount we take home after all deductions have been made. Why, then, should we care about the amount you earned before deductions, or gross pay, if you’re not bringing that money home? In this article, we’ll explain the difference between gross pay and net pay, and why it’s important to understand both when it comes to budgeting and financial planning.

Gross & Net Income Key Terms

What is Gross Pay?

Gross pay goes by many names which include pre-tax income, earned income, salary, or annual pay. Gross income is the total amount earned before any deductions have been made. It Includes any overtime pay, bonuses, and commissions earned by the employee, as well as their regular hourly or salary wages. Gross salary can also come from many different sources other than employment such as dividends from stocks or bonds, pensions, rental income, inheritances and much more. It is the total amount that the employer owes the employee. 

Calculating Gross Pay

Gross income is calculated by multiplying an hourly wage by the number of hours worked. For example, if you earn $20 an hour and work 40 hours a week, your gross pay would be $800. It’s important to note that gross pay is often used as the base for other calculations, such as calculating deductions or benefits

Pay SchedulePay PeriodsFormula
Weekly 5252 x (hours per pay period) x (wage per hour)
Bi-Weekly2626 x (hours per pay period) x (wage per hour)
Semi-Monthly2424 x (hours per pay period) x (wage per hour)
Monthly1212 x (hours per pay period) x (wage per hour)
Net pay

Adjusted Gross Income

Adjusted gross income (AGI) is a term used in the United States tax code. It is a measure of a person’s or household’s income that is used to calculate the amount of taxes owed. 

The AGI is an important number in the U.S. tax code because it is used to determine a taxpayer’s eligibility for certain deductions and credits, as well as their marginal tax rate. Some deductions, credits, and exemptions are based on AGI, the lower is your AGI the more benefits you are eligible for. Also some government benefits like Medicaid are based on the AGI. It is also used as a threshold for determining whether a person or household is subject to certain taxes or penalties. For example, in 2021, the AGI threshold for paying the Medicare surtax on net investment income is $250,000 for married filing jointly, $200,000 for single.

AGI is reported on the first page of the federal income tax return Form 1040 in the U.S. and is used to calculate the total tax liability of the person or household.

Calculating Adjusted Gross Income

AGI is calculated by taking a person’s or household’s gross income (total income before any deductions or exemptions are applied) and subtracting certain adjustments, or “above-the-line” deductions. These deductions include things like contributions to certain retirement accounts, certain business expenses for the self-employed, and certain education expenses. Although the terms sound similar, AGI is not the same as net income. Your net income is calculated after taxes so it is not subjected to further taxation while your AGI, although adjusted, is still taxable.

Modified Adjusted Gross Income

Modified Adjusted Gross Income (MAGI) is a measure of a person’s or household’s income that is used to determine eligibility for certain tax benefits and credits. It is similar to adjusted gross income (AGI), but with certain adjustments added back in.

MAGI is used as an eligibility criteria to determine whether an individual is eligible for certain tax credits and deductions, such as the child tax credit, education credits, the premium tax credit and certain Roth IRA contribution limits. MAGI is also used to calculate the income-related monthly adjustment amount (IRMAA) for Medicare Part B and Part D premiums.

MAGI is also commonly used as a measure of income when determining financial aid eligibility for students. Most of the financial aid packages like FAFSA use MAGI as a criteria to determine the aid amount.

Calculating Modified Adjusted Gross Income

MAGI is calculated by starting with AGI and then adding back certain deductions that were used to arrive at AGI. For example, certain deductions for foreign earned income, student loan interest deduction or rental real estate losses would be added back to AGI to arrive at MAGI. The specific adjustments that are included or excluded from the calculation of MAGI can vary depending on the context and the source.

Deductions

Deductions are amounts that are subtracted from an employee’s gross pay. Common deductions include payroll taxes, income taxes, and pretax deductions. Payroll taxes include Social Security and Medicare tax rates. Income taxes are calculated based on your total earned income and includes state and local income taxes. Pretax deductions are usually retirement and healthcare contributions. For example, if you earn $800 in gross pay and are subject to a 20% federal income tax, $160 will be deducted from your gross pay for taxes.

Calculating Net Pay

What is Net Pay?

Net salary, also known as take-home pay, is the amount you receive after all deductions have been made. Companies may also call this net profit or after-tax income. To calculate net pay, you subtract all deductions from your gross pay. Using the example above, if you earned $800 in gross pay and had $160 in taxes deducted, your net pay would be $640.

Other Common Terms for Income

In addition to net and gross income, you may also come across the terms “countable income” and “qualifying income.” They are terms that are used in the context of government benefit programs, particularly those related to financial assistance and means-tested benefits.

Countable income is the income that is taken into consideration when determining a person’s eligibility for government benefits such as Medicaid or Supplemental Nutrition Assistance Program (SNAP) . The government sets specific income limits for these programs, and only the income above those limits is considered countable income. Countable income usually includes gross wages, salaries, tips, commission and other forms of income, minus any applicable deductions or credits.

Qualifying income, on the other hand, is the amount of income that meets the specific criteria or standards set by the government to determine eligibility for a benefit or program. Qualifying income may be based on gross income, adjusted gross income, or modified adjusted gross income. These criteria are often established to ensure that the benefit is targeted to those who are most in need, and to control the costs of the program.

For example, to be eligible for Medicaid or SNAP, a person’s countable income must be below a certain threshold. To be eligible for the Earned Income Tax Credit, a person must have a certain level of qualifying income from earned wages or self-employment.

It’s important to note that different programs may use different criteria for determining countable and qualifying income, so it is crucial to check the specific rules for each program you’re considering.

Tools to Assist with Calculating Net Pay

There are several tools that can help people calculate their net pay, including:

  1. Payroll calculators: Many online payroll calculators are available that can help people estimate their net pay based on their gross pay, deductions, and taxes. These calculators typically require input of basic information such as gross pay, federal income tax withholding, state income tax withholding, and any other deductions or pre-tax contributions (401k, health savings account, etc).
  2. Spreadsheets: Many people create a spreadsheet to calculate their net pay. This can be a helpful tool for those who want more control over the calculations and for keeping a record of past paychecks.
  3. Tax preparation software: Tax preparation software such as TurboTax or H&R Block can be used to estimate a person’s net pay. These programs are intended to prepare taxes but they also include salary calculators that can be used to estimate net pay based on gross pay, deductions and taxes.
  4. Employer’s pay stubs: Employers are required to provide the employee a pay stub that shows the employee their gross pay, taxes and other deductions. This pay stub can be used to estimate their net pay.

It’s important to note that these tools are intended to provide estimates and may not match the exact net pay a person receives on their paycheck. Factors such as taxes, deductions and other withheld amounts may change from paycheck to paycheck, based on personal circumstance, rate changes and legal requirements.

Implications of Gross Pay vs. Net Pay

Gross and net income are important for several reasons. Some of the key reasons include:

  1. Taxation: Gross income is used to calculate taxes owed to the government. In the U.S., for example, people are required to report their gross income to the Internal Revenue Service (IRS) and pay taxes based on the amount they earn.
  2. Budgeting and financial planning: Gross income is the starting point for creating a budget and financial plan. Knowing how much money is coming in each month is crucial for determining how much can be spent, saved, or invested.
  3. Eligibility for government benefits: Some government benefits, such as Medicaid and SNAP are based on the gross income. It is considered as a measure of a person’s ability to provide for themselves and their family. Knowing your gross income can help you determine whether you are eligible for these programs.
  4. Creditworthiness: Gross income is an important factor that lenders and creditors use when evaluating a person’s creditworthiness. It is often used to determine a person’s ability to repay a loan or credit card balance.
  5. Retirement planning: For retirement planning, gross income is a key factor in calculating how much money will be needed in retirement. Knowing your gross income and how it may change over time can help you create a retirement savings plan that will help you achieve your goals.
  6. Business decision making: In case of businesses, Gross income is a key metric that helps business owners to make decisions like hiring new staff, expansion and other investments. It also used to gauge the profitability and sustainability of a business.

It’s important to understand the difference between gross pay and net pay, as it can have a significant impact on your budget and financial planning. For example, if you’re considering taking on a new job, it’s important to know the potential impact of deductions on your take-home pay. Annual gross pay is also key to major financial decisions such as buying a home. Mortgage lenders and property owners use annual gross pay as an indicator of your financial reliability. Knowing your gross pay and deductions can help you budget more effectively, as it gives you a better idea of your true income.

As an employer, many employees may have questions about how their deductions are being calculated or why their salary is being deducted at all. Being able to explain how deductions work and knowing exactly where those deductions are coming from by having a detailed history of gross and net income is essential to mitigating these concerns early on. 

Gross Pay VS Net Pay: An Important Distinction

In conclusion, understanding the difference between gross pay and net pay is crucial when it comes to budgeting and financial planning, determining the amount of taxes paid, evaluating compensation packages, retirement planning, and meeting financial obligations. We encourage you to calculate your gross and net pay, and to consider the implications on your finances. Remember, keeping track of your pay will help you make more informed financial decisions.

Gross salary vs Net salary

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