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Gross vs. net income: Which one should you use when budgeting?

Making a budget doesn't have to be hard, but there are a few simple mistakes you'll need to avoid. One of the most common missteps people make is getting their gross and net income mixed up.

These two terms might seem interchangeable, but there's a big difference between the two. If you mix them up and use your gross income to make your budget, you could end up spending money you don't have. Fortunately, it's an easy budgeting mistake to fix.

Gross and net income are two terms that describe different ways of measuring your income. Here's what sets them apart:

Gross income: This is the wages or salary you earn before taxes, benefits, and any other deductions are taken out. Sometimes referred to as your "before tax" pay, this is usually the largest number you see on your pay stub.
Net income: Also known as take-home pay, your net income is the amount of money you receive in your paycheck after taxes and other withholdings are taken out. This number is lower than your gross income and represents the amount you can actually spend or save.

Many people get frustrated when they realize how much lower their net income is than their gross income.

Why does so much money come out of your paycheck? For one, your employer has to withhold a portion to cover payroll taxes and income tax. You might also live in a state with relatively high income taxes, such as California, Hawaii, or Oregon. Plus, certain other benefits and expenses, such as 401(k) contributions and health insurance premiums, are typically deducted from your gross pay.

You can take a look at your pay stub to see what's being withheld. Here's what you might see:

Social Security (6.2%)
Medicare (1.45%)
Federal income taxes (10% to 37%)
State or local taxes
Health insurance
Retirement contribution
Union dues
Child support
Wage garnishments

Using gross income for your budget is a recipe for failure. Why? When you use gross income, you "double count" your money, meaning you set yourself up to spend money that's already going elsewhere.

To avoid double-counting, make sure you use your net income and don't include the items withheld from your paycheck in your budget. For example, if you contribute to an employer-sponsored retirement plan, like a 401(k) or 403(b), don't add that contribution amount as a budget expense.

For most people, making a budget based on your average monthly net income is the best approach. Using this figure frees you from having to create a different budget every time your income fluctuates while also letting you see if your average income is enough to cover your regular, month-to-month expenses.

Unfortunately, many people skip a few steps when calculating their average monthly income. Here's how you can do it the right way:

1. Start by finding your net income from your three most recent paychecks.

2. Calculate your average monthly income. This is easy to do if you're paid monthly. But it involves some math if you're paid weekly or every other week since you don't receive the same number of paychecks every month. Here's how you can find the right number:

Biweekly formula:

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

Weekly formula:

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 income fluctuates — maybe due to seasonal employment or working lots of overtime — it can be tricky to pinpoint a useful figure. But there are methods that can help you estimate your net income and stick to a budget:

Tax returns: If you have similar fluctuations every year, use your average net pay from the past two to three years of tax returns.
Be conservative: If you're unsure what you'll earn, be conservative. Use a figure that reflects your net pay during a lean month to make sure your lowest level of income covers all your basic needs.
Focus on expenses: Make sure you know how much your monthly expenses add up to so you can prepare in advance if your income is expected to fall short.
Save more: To cover yourself during the lean months, budget to save as much as possible during the good months.

You can potentially increase your net income by reducing your voluntary deductions, such as your retirement contribution, and/or by reducing your tax deductions. Just be careful since these changes can potentially increase your annual tax bill.

Another option could be to move to one of the seven states with no income tax, such as Florida, Nevada, or Texas.

Where can I find my net and gross income?

You can find both your net and gross income on your pay stub. The gross figure is usually toward the top of the document and is the largest income figure shown. For net, you can look for the item listed as "take-home pay" or "net pay."

Your net income could be low for a few different reasons, including high tax deductions or retirement contributions. To find out exactly what's being withheld, take a look at your pay stub. Someone in your payroll or HR department may also be able to help you find answers.

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