To create a successful budget, you first have to make sure you fully understand your income

For most of us, income is the easiest-to-understand part of your budget. You know how much you make (usually $100 shy of enough) and how often it comes in (at least a day late). It’s figuring out where all income goes each month that’s the hard part.

But just because income is somewhat easier to keep track of than other aspects of your financial life doesn’t mean you can afford to ignore it. A thorough understanding of your monthly and annual income is the foundation of a strong budget. You can’t build a solid financial life without this understanding.

Here’s everything you need to know about your income.

What is income?

While the definition of income may seem obvious, it’s helpful to spell out exactly what this important part of your financial life is. Specifically, your income is the entire amount of money that flows into your budget over a period of time. This includes money you earn through work—your salary, wages, bonuses—or money you earn through investments, such as dividends or rental income.

Your earned income can also be broken down further into your gross versus net income. Understanding the difference between these two amounts will help you make more accurate financial decisions.

Gross versus net income

Gross income refers to the amount of money your employer pays you before taxes, benefits, and other payroll deductions are taken from your paycheck. Net income is the amount of money that you actually get to take home with you.

Anyone who has been excited to get their first paycheck—only to be left wondering who FICA is and why he’s taking all your money–will recognize the big disparity between gross and net income. According to 2023 data from the Census Bureau, the median gross household income in 2022 was $74,580, while the median household income after taxes was $64,240, or nearly 14% lower than the gross income.

But even though taxes are part of the reason for the size of your net pay, they are not the only deductions taken.

Nothing but net (income)

Taxes may take the biggest bite out of your gross pay, but there are several common deductions that can affect your net pay, including:

• Federal income tax withholding: Income taxes are calculated based on your income and increase progressively, so that higher-income earners ostensibly pay more than lower-income earners.
• State income tax withholding: If your state imposes income taxes, it will generally be withheld from your pay like federal income taxes.
• Social Security and Medicare taxes: The Federal Insurance Contribution Act (FICA) charges employees a tax rate of 6.2% for Social Security and 1.45% for Medicare, while your employer is required to match that contribution amount.
• Health insurance premiums: Typically, if your employer provides health insurance, your contribution is deducted from your paycheck each pay period.
• Retirement savings: If you have access to a retirement investment account through work, you can make contributions to the account from your gross pay, which lowers your net pay—and your taxable income.
• Wage garnishment: If you have incurred debt, such as unpaid back taxes, alimony, child support, or student loans, a court can order your employer to withhold a percentage of your wage until the debt is repaid.

Adjusting your withholding

Taxes may be one of only two certainties in life, but people working a traditional job have more control over the taxes coming out of their paychecks than they might realize. That’s because the W-4 form you filled out with your employer’s HR department at the start of this job determines your withholding, and you can adjust the withholding by submitting a new W-4 form.

If you regularly receive a large tax refund, you can recalculate your withholding allowances on the IRS.gov website, and use your corrected withholding to fill out a new W-4 form. This will increase the amount of net pay you receive with each paycheck. (You can also adjust your withholding in the other direction, if you would like to send more money to Uncle Sam. There are many taxpayers who use this strategy as a form of enforced savings.)

The withholding you claim on your W-4 only determines the amount deducted from your paycheck in taxes each pay period. It is not the same thing as your tax bill. Which means it’s perfectly legal to change withholding allowances on your W-4, as long as you claim the correct number of allowances on your actual tax return. Just note that adjustments to your withholding will affect your tax refund.

Know thy income

Without understanding your monthly income, it is impossible to create an accurate budget. That’s why you must start any personal money management practice by calculating exactly how much money you bring home.

This calculation is simple for those who have a traditional job with a regular paycheck. If you get paid weekly, simply multiply your pay by four to get your monthly income. For biweekly or semimonthly paychecks (i.e. getting paid on the first and 15th of each month), multiply your pay by two to get your monthly income.

Freelancers, contract employees, and salespeople who work on commission have a tougher calculation to complete to determine their median monthly income. If you have an irregular income, you can calculate an approximate monthly take home by adding together a year’s worth of irregular income, then dividing the total by 12. (If you haven’t been earning an irregular income for a full year, use as many months’ worth of income as you’ve earned, and divide the total by that number of months).

Once you have this dollar amount calculated, you can start planning how you use your money, rather than simply wondering where it all went when you’re paying for gas with couch cushion change.

The importance of income

Becoming a master of your money does not require arcane knowledge or extreme self-restraint. You only need to understand the five pillars of financial literacy, starting with income.

Income describes the amount of money that flows into your budget over a period of time. Your gross income is the amount of money you earn before anything is deducted from your paycheck, while your net income is the money you actually get to take home.

While taxes are one of the common deductions taken from your gross pay, you may also have such things as health insurance premiums, retirement contributions, and wage garnishments deducted from your pay. It’s not possible to opt out of paying taxes, but you can adjust the amount of money that is withheld from your paycheck by filing a new W-4 form with your employer. This is perfectly legal, but it will affect your tax refund amount.

Knowing your monthly income is the basis of accurate budgeting. If you have a regular income, you can calculate an exact monthly income, but even workers with irregular income can set up a budget using an approximate median monthly income.