Income

What is Income?

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 salaries, revenue from self-employment, commissions, and bonuses. Other types of income include social security, pensions, stock option plans, and income from a 401k plan. These sources of income are typically earned by retired persons.

For companies, net income earned during a specific period is obtained by summing all the revenues earned by the business minus taxes 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 received, 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 income is revenue 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 income 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, depreciation, interest expense, and tax. This key figure is found at the bottom (“the bottom line”) of the profit and loss (P&L) statement. It is the profit attributable to shareholders, and it is used to calculate earnings per share (EPS).

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

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

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

• Accounting Fundamentals Course (FREE)
• Capital Gain
• Fringe Benefits
• Products and Services
• See all accounting resources