Before understanding the net income definition, you should know that the term applies to both individuals and businesses. For individuals, it's usually the amount of income earned after taxes and other deductions are taken out of your weekly salary. For businesses, net income is the amount of revenue made after subtracting expenses such as taxes and money spent on products. Many businesses refer to this figure as their bottom line or net profit as well. Some people often confuse net income with gross income, which is the amount of income or revenue earned before deducting taxes and other expenses.
How do you calculate net income?
A simple equation for calculating your net income is:
Total Amount Earned (Gross Income) - Paycheck Deductions = Net Income
For example, imagine you worked 40 hours last week and made $2,000. Your employer deducted $250 for federal and state taxes, $100 for Medicare and Social Security taxes, another $100 for your contribution to your retirement plan, and $80 towards your healthcare plan. You would subtract those deductions from the initial amount you earned to find your net income:
$2,000 - $250 - $100 - $100 - 80 = $1,470
$1,470 is your net income.
Net income and your personal paycheck
Many employee paychecks actually list the net income on the pay stub. However, to avoid confusion, your net income is almost always the amount of actual cash your bank will give you or that you will deposit when you're paid. Deductions on each individual paycheck may vary, but some common ones that could affect the difference between your gross and net incomes include:
- Federal and state income tax
- Social security tax
- Medicare tax
- Local tax
- Healthcare-related benefits (usually medical, dental and vision)
- Mandatory court-ordered payments (such as child support, Chapter 13, wage garnishment, tax levy, and student loan payments)
- Contributions to a retirement account
- Charitable contributions
Net income and your individual taxes
As an individual, you may assume that your net income is essential when it comes to your taxes. However, the truth is that your net income isn't relevant when you file your taxes with the IRS each year. Instead, your gross income, taxable income, and adjusted gross income are taken into consideration.
Net income and your business
If you are a small business owner, your business also has a net income. The following formula is an easy way to determine your business's net income.
Total Revenue - All Business Expenses = Net Income
While net income isn't relevant to your individual taxes, it can play a major role in the way you run your business. A major change in your business's net income could indicate a larger problem. Typically, you might find a sudden decrease in sales of products and services, poor accounting or financial management, or multiple cases of bad customer service in a short period of time. If you have shareholders, they'll often look to your net income to determine their next move. Low or even negative net income could result in a big drop in the value of your company's shares.
On the other hand, steady net income numbers mean you're staying, and even thriving, in business. Most successful business owners invest some of their net income back into the business, but if this money isn't available, you must either shut down the business or seek loans and other sources of funding. Investing your net income back into your business also means saving money on expenditures such as loan interest and being in total control of how you operate your company. If the need for a loan or additional financing ever does arise — maybe you want to expand the business — banks and investors look more favorably at companies that have been existing comfortably on their own net income. These organizations may even use the number to help determine your company's value.