There are a plethora of possibilities when it comes to budgeting. That’s the beauty of personal finance – you’re allowed to personalize your budget based on your lifestyle, your mindset, your wants, your needs, how frequently you get paid, and how frequently you want to update your budget.
Some families like to map out where every single penny will be spent, saved, or invested, while others just try to spend less than what they’re bringing in each month, without always knowing how every dollar will be spent in advance.
While there are hundreds if not thousands of different ways to budget, there are some universal truths when it comes to budgeting. For example, it’s best to not spend more than you’re bringing in, and your budgeting income should be based on your net income, not your gross income.
Net Income vs. Gross Income
There’s a difference between “net income” and “gross income.” But if you’re anything like me, it’s easy to forget what exactly that distinction is from time to time so here’s a brief reminder:
Gross income is the amount of money you earn before deductions like taxes are taken out.
Think of gross income as a clean, rounded number like a salary. If you take a job position that pays $40,000 per year, then your gross income will be $40,000. If you have multiple sources of income—say a full-time job paying $40,000 and a part-time job paying $10,000—your gross income would be $50,000.
Net income on the other hand is what is leftover from your gross income after the deductions are taken out, which is why it’s also known as take-home pay.
The simplest example is when your employer withholds taxes from your paycheck. Your gross income is reduced by your withheld tax amount and what remains is your net income. In addition to tax withholdings, your employer may also withhold funds for retirement contributions, health insurance premiums, or other benefits.
Knowing the difference between your gross income and net income could be the difference between a budget that either attracts or dispels financial stability.
For example, in California, someone earning a $50,000 gross income salary would take home or net about $38,697, according to an analysis of take-home pay rates in all 50 states by GoBanking Rates. That’s a little less than the national take-home pay average of $39,129, or about $3,260.75 per month.
Why Net Income is Best for Budgets
Budgets don’t just help us try to spend less than what we’re bringing in, but budgets also help us understand what we can afford. For example, you may have heard the old finance rules of thumb such as you should spend 30 percent or less of your income on housing, or that transportation costs should always be less than 10 percent of your monthly income.
Well, going based on the research from GoBanking Rates, if you based your budget on your gross income ($50,000), a 30 percent budget would leave you with about $1,250 to spend on housing each month. But if you determined your housing budget based on your net income, you would be left with a housing budget of around $967 per month.
The difference between a monthly housing payment that costs $967 and $1,250 may not be large for some, but for others, the difference could be great enough to create financial instability.
While this is just one simple example, you can see how the distinction between net and gross income makes a very big difference in your budget.
If you’ve been budgeting using your gross income, this is your invitation to switch out those numbers and see how your experience with budgeting changes. If you’ve been budgeting using your net-income, double-check the deductions from your paycheck and see if you want to make any adjustments.