Gross Pay vs Net Pay: What’s the Difference?
Many of us remember the feeling of anticipation at our first part-time job before that first long-awaited paycheck from our employer. Excitement may have quickly turned to sticker shock when we witnessed the actual amount on that first check. Realizing that your net income is different from your total gross earnings is one of the first life lessons in employment.
Although you've likely grown since that first job, you may still have some questions about the difference between gross pay vs net pay. In this article, we'll shed light on the differences between gross and net pay and offer practical payroll insights for employees.
Here’s What We’ll Cover:
What is Gross Pay?
Gross pay is the total amount that an employer agrees to pay you for your time and work during a given pay period. The full gross income amount is calculated either through a set salary or from your hourly wage multiplied by the number of hours worked.
Gross pay is also the amount of money that appears on a pay stub before deductions, taxes, and other contributions are subtracted. An employee's gross pay amount always changes after these deductions are made.
Why is Gross Pay Important?
Although you won't see your gross pay amount deposited into your account, it's still helpful to know and understand this figure. There are several reasons why you should be aware of gross pay and a few ways that it comes in handy.
Your personal gross pay amount can:
- Contribute to your financial success when and if you receive a promotion or negotiate a salary
- Confirm your hourly rate based on the number of hours worked (in addition to overtime pay)
- Allow you to see how much house you can afford when pre-applying for a new mortgage
- Provide insight into your pre-tax deductions per pay period
Always keep in mind that when you receive a job offer, it usually indicates gross pay. For example, when an employer extends an offer of $75,000 per year, this is gross income only.
What Deductions are Made from Gross Pay?
The reason that gross income is different from net income is that payroll deductions take place prior to an employee receiving a paycheck. These deductions and payroll taxes are covered in more detail below.
As an employee in the United States, you are obligated to pay income tax. These taxes include both federal income tax (tracked by the Internal Revenue Service) and state or local income tax that you owe based on where you live. Typically, these taxes are automatically calculated based on the payroll information you submit when your employer hires you.
FICA contributions correspond to the Federal Insurance Contributions Act. These contributions correspond to two major areas: Social Security tax and Medicare tax. Deductions are made from each paycheck in order to fund these important federal programs.
Anyone who works as a W-2 employee in the United States benefits from a shared FICA tax contribution. This simply means that the employer pays a percentage of these taxes on behalf of the employee.
The mutual contribution does not apply to self-employed individuals or independent contractors.
Gross income is also affected by monthly insurance premiums. On a standard paycheck, this most often takes place in the form of health insurance and life insurance.
Employers automatically deduct these contributions based on the selections that an employee makes during open enrollment periods.
Gross pay is not just affected by required contributions and taxes. There are a few other paycheck deductions that are either optional or personalized to the employee's preferences. Optional contributions include:
- Retirement plans (such as a 401k or 403b)
- Stock purchase plans, if offered by the company
- Flexible Spending Accounts (FSA) and Health Savings Accounts (HSA)
- College savings plans
- Voluntary wage garnishments
- Other health, wellness, or financial incentives offered per employer
What is Net Pay?
In the gross pay vs net pay discussion, net pay is the amount of "take-home" money that an employee expects to receive when their job duties are fulfilled. Net pay is the amount of money left over after all taxes, deductions, and optional contributions have been made.
Regardless of how often you receive a paycheck (weekly, bi-weekly, or monthly), net pay is always the amount that is left after your employer adjusts financial compensation through the standard payroll process.
Why is Net Pay Important?
Since net pay is the money that will actually hit your bank account each pay period, it's often the amount that matters most to financial activities like spending and budgeting.
You should never budget or spend based on your gross pay alone, as this could lead to using and accounting for money that you don't actually have.
Net pay is also important because it paints the full picture of your tax payment situation. After all, the reason that net pay is less than gross pay is that you owe and pay taxes on the money you earn. As an employee, it's important that you pay attention to these amounts and update your employer if any life changes affect your tax status.
How to Maximize Net Pay
By now, you may have realized that the difference between gross pay and net pay is significant. If you are shocked about how much money you're not depositing after each pay cycle, the following reminders can help you appreciate and maximize net pay.
- Pre-tax contributions are a healthy and preferred way to grow retirement investments (and build a substantial nest egg over time).
- Creating a realistic monthly budget can help you see and understand exactly where net pay goes each month (and how to reduce unnecessary spending).
- Make sure that you use personal tax allowances if you want to increase net pay.
- Request employer reimbursement for any job-related travel or expenses. This adds to your take-home pay without affecting your established gross income.
Many employees aspire to increase net pay throughout their careers and over time. This is most often accomplished through salary negotiations, promotions, or changing roles and companies.
How to Adjust Net Pay Amounts
Occasionally, you may want to increase or adjust the amount of net pay you receive each pay cycle. Since employers and payroll departments calculate taxes and payroll contributions directly from a W-4 Form (known as the Employee's Withholding Certificate), you should make official changes using this form.
You might choose to adjust the withholdings on your W-4 Form if:
- You experience a significant life change (marriage, divorce, the birth of a child, etc.)
- Your previous tax return revealed that you paid an excessive amount of taxes
- Your previous tax return revealed that you paid too little taxes
- You started another role or picked up a second job
Any time you want to adjust your net pay, always use the most recent version of Form W-4 directly from the IRS. You can then fill out the form with changes, submit it to your employer or HR department, and tweak your future withholdings as needed.
Are Gross Pay and Net Pay Important at Tax Time?
Before you file an annual tax return, your employer prepares a W-2 form that lists your gross pay amount in Boxes 3 and 5.
The amount listed in these boxes may be different from the gross income amount you see in Box 1, because Box 1 only lists the amount of income that is taxable. If you made any pre-tax contributions, these would be excluded from the Box 1 calculation.
When it comes time to verify your payroll taxes for the year, your net pay amount is not necessary. Instead, you (and your tax preparer) can ensure that you have paid enough taxes by using the specific amounts listed in the other boxes on each W-2 form you receive.
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