Understanding Income: Definition, Types & Uses

Income refers to the money that is earned by an individual for providing a service or as an exchange for providing a product. The income earned by an individual is used to fund their day-to-day expenditures, as well as fund investments. Some of the most common types of income include salariesRemunerationRemuneration is any type of compensation or payment that an individual or employee receives as payment for their services or the work that they do for an organization or company. It includes whatever base salary an employee receives, along with other types of payment that accrue during the course of their work, which, revenue from self-employment, commissions, and bonuses. Other types of income include social securitySocial SecuritySocial Security is a US federal government program that provides social insurance and benefits to people with inadequate or no income. The first Social, pensions, stock option plansEmployee Stock Ownership Plan (ESOP)An Employee Stock Ownership Plan (ESOP) refers to an employee benefit plan that gives the employees an ownership stake in the company. The employer allocates a percentage of the company’s shares to each eligible employee at no upfront cost. The distribution of shares may be based on the employee’s pay scale, terms of, and income from a 401k plan. These sources of income are typically earned by retired persons.

For companiesCompaniesLists of the main players in corporate finance. We've got lists of the most important financial services companies, banks, institutions, accounting firms, and corporations in the industry. Browse these guides to prepare for a career in financial services and start networking today to accelerate your career, net incomeNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through earned during a specific period is obtained by summing all the revenues earned by the business minus taxesDirect TaxesDirect taxes are one type of taxes an individual pays that are paid straight or directly to the government, such as income tax, poll tax, land tax, and and business expenses. This is an important metric for investors analyzing a company.

Taxable Income

Taxable income is the amount used to calculate how much tax an individual owes the government. All the salaries, wages, dividends, interest receivedInterest IncomeInterest income is the amount paid to an entity for lending its money or letting another entity use its funds. On a larger scale, interest income is the amount earned by an investor’s money that he places in an investment or project., pension, or capital gains earned during the year are taken into account when calculating taxable income.

Income tax laws vary in every country, state, or province. It is important to understand your tax obligations in accordance with local law.

Filing Taxes

For employed individuals, payroll is set to automatically deduct taxes such as social security, federal, and state taxes. However, it is different for self-employed individuals who must pay taxes directly to the US Internal Revenue Service (IRS). A self-employed person must calculate the amount of taxes they owe to the government, and then make a lump sum payment by tax payment deadline in April, or make quarterly payments.

Self-employed individuals with employees are required to notify the employees who they worked with during the year to file taxes if the company did not withhold their income taxes. In a situation where an employee has claimed an exemption from withholding, the employer is not required to notify them formally.

Tax-Exempt Income

Tax-exempt income is money earned by an individual or company that is not subject to federal or state taxes, as determined by the IRS. The following are examples of tax-exempt benefits:

• Interest from U.S. Treasury bonds (exempt from both state and federal taxes)
• Employer-sponsored supplemental disability insurance purchased with after-tax dollars
• Distributions from Roth 401(K) plans
• Interest on municipal bonds (exempt from state and federal taxes)
• Capital losses from sold assets (exempt up to $3,000 per year)

Gross vs. Net

Gross incomeGross IncomeGross income refers to the total income earned by an individual on a paycheck before taxes and other deductions. It comprises all incomes is revenueRevenueRevenue is the value of all sales of goods and services recognized by a company in a period. Revenue (also referred to as Sales or Income) before any taxes and deductions have been deducted. It sums up the revenue from all sources, including non-cash items such as services and property. For most salaried individuals, their gross income is the total salary before tax and deductions. Some individuals may have additional sources of income such as dividends, capital gains, rent received, tips, etc.

For a company, gross earnings are calculated by summing all revenues earned from the sale of products and services minus the cost of goods sold (COGS). Both lenders and landlords consider gross income when determining whether an individual or company will be able to honor their obligations.

On the other hand, the net incomeNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through of an individual is their gross, minus taxes and deductions. It is the amount of money individuals take home, and that is available to spend on day-to-day expenditures.

The net income for a company is calculated by summing all the business revenues, minus the cost of goods sold, business expenses, operating expenses, depreciationDepreciation ExpenseWhen a long-term asset is purchased, it should be capitalized instead of being expensed in the accounting period it is purchased in., interest expense, and tax. This key figure is found at the bottom (“the bottom line”) of the profit and loss (P&L) statementProfit and Loss Statement (P&L)A profit and loss statement (P&L), or income statement or statement of operations, is a financial report that provides a summary of a. It is the profit attributable to shareholders, and it is used to calculate earnings per share (EPS)Earnings Per Share (EPS)Earnings per share (EPS) is a key metric used to determine the common shareholder's portion of the company’s profit. EPS measures each common share's profit.

Disposable vs. Discretionary

Disposable income is the amount of money that is available for spending after deducting taxes. It is typically spent on necessities such as food, clothing, housing, transport. For example, assume that an individual earned $150,000 during the last financial year and the rate for their tax bracket is 30%. This means that their disposable income will be $150,000* (1 – 0.3) = $105,000, where 0.3 is the tax rate.

The disposable income of the citizens of a country is constantly monitored by different government agencies as a key economic indicator, and it is a good proxy for the overall health of the economy.

Discretionary income is the amount of money earned that is available for an individual to spend, save, or invest, after paying for all their necessities. This is money that can be spent as the user chooses, on vacations, luxury goods, or other non-essential goods or services. For example, if an individual earns $5,000 per month after taxes, and spends $3,500 in paying for necessities, the remaining $1,500 is their discretionary income.

Related Readings

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Accounting Fundamentals Course (FREE)
• Capital GainCapital GainA capital gain is an increase in the value of an asset or investment resulting from the price appreciation of the asset or investment. In other words, the gain occurs when the current or sale price of an asset or investment exceeds its purchase price.
• Fringe BenefitsFringe BenefitsFringe benefits are the additional benefits offered to an employee, above the stated salary for the performance of a specific service. Some fringe benefits such as social security and health insurance are required by law, while others are voluntarily provided by the employer.
• Products and ServicesProducts and ServicesA product is a tangible item that is put on the market for acquisition, attention, or consumption while a service is an intangible item, which arises from