Are you familiar with the difference between gross and net income? If so, which one should you use when you are budgeting for major purchases? As it turns out, the concepts of “gross” and “net” incomes are very simple, but the implementation can be a bit more complicated. In this post we will give you a quick refresher about the differences between the two terms and how you can use them when budgeting.

Gross vs. Net Income Explained

One quick note: we are focused exclusively on these terms in the context of personal finance. While the concepts are certainly very similar across other contexts, like business usage, just remember that we are talking about your personal income.

Your gross income is the total amount you are paid before any deductions. In most cases this will be income from your employer. It is the equivalent of your salary. If you take a job position that pays $40,000 per year, then your gross income will be $40,000. Now, if you have multiple sources of income—say a full-time job paying $40,000 and a part-time job paying $10,000—then your gross income would include the second source. You would therefore have a gross income of $50,000.

Your net income is your gross income minus deductions. It is also referred to as your 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. Whatever is withheld, the remainder is your net income.

Which Income Figure Should You Use for Budgeting?

When you are making a budget, you will want to determine whether to use your gross or net income in your planning. This will vary depending on which budgeting tool you use. Some may instruct you to list your gross income, and then taxes and deductions will be line items as expenses. Others may ask you to start with your net pay. If you start with your net pay, you will just need to ensure that you don’t double count an expense in your budget (like health insurance premiums) that may have already been deducted from your pay.

Deciding which income figure to use is a relatively minor detail when it comes to general, monthly budgeting because your budget tool will guide you, or if you budget by hand you can figure out which way is preferable to you.

However, it can be a very important detail when you are budgeting for specific large purchases. Just to give a few quick examples—have you heard the “rule” that you should spend 30 percent or less of your income on housing? Or that transportation costs should account for less than 10 percent of your monthly income?

These guidelines and others like them can be very helpful for thinking about your financial well-being and making plans for your future. However, before you ever complete a purchase using one of these principles, you should know whether you are making calculations based on net or gross income.

In the links above, the guideline about housing costs uses net income. Meanwhile, the tip about transportation costs uses gross income.

Why It Matters

GoBankingRates has published a list of how much the average resident in all 50 states would take home as net income based on a $50,000 salary (gross income). According to that post, in California someone with a $50,000 salary would net $38,697. When divided by 12, that comes out to $3,224.75 per month.

Following the housing rule above, that leaves a housing budget of about $967 per month (30 percent of $3,224.75). Had you used gross income for the calculation, you would have arrived at a housing budget of about $1,250 per month. This is a huge difference, as for some people a rent of $1,250 would not be affordable.

This is just one simple example, but you can probably see how the distinction between net and gross income can a make a very big difference in whether a course of action will be a good financial move or not. If you use gross income in your calculation when you should have used net, you may end up on a path that is not financially sustainable.

Other Common Pitfalls

While we are already on the subject of gross vs. net income, here are a few minor “pitfalls” related to these two types of income. Keeping these in mind will deepen your financial understanding and help you keep a predictable budget.

Don’t Double Count Expenses

We mentioned this briefly before. If you use a budgeting tool that asks you to start with net income, be sure that you have a way of tracking your deductions. For example, let’s say that you have retirement contributions taken out of your paycheck each month. If you make a budget based on net income, then your starting point will be after the retirement savings have already come out.

When you get to the line item for “retirement” on your budget, you would need to exclude the amount already deducted from your check. This might mean putting zero dollars, or listing other retirement savings you made outside of your paycheck. You wouldn’t want to count an expense twice because that would throw off your whole budget.

Also important—you will want to keep your deductions in mind and not forget about them. There may be some optimizations and improvements you could make to your deductions and if they are totally out of sight and mind you might not think about them very often.

Remember Taxes

This is somewhat related to the point above, but don’t forget about your taxes. If you get a large refund each year, then in a way that means your net income is higher than your paychecks indicate, because you are essentially having too much withheld throughout the year. You can change your withholding by working with HR at your employer to do so. Or, you may prefer having a large refund, which can operate in some ways like a zero-interest savings account. Either way, remember that tax withholdings will affect your net pay.

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We have talked before about setting financial goals for 2021. Given the difficult year that was 2020, it seems likely that many people will set New Year’s resolutions around their financial well-being. Because your finances are so important, you will want to make sure that you set yourself up for success and do not struggle to gain traction. The key to hitting your financial goals is to have a financial plan in place that gives you the structure you need to be successful. Here are some suggestions for how to do just that.

Clearly Define Your Goal

The first step is to define your goal. Be clear about exactly what you want to achieve. Again, this goes back to the framework that your goals should be SMART. As a reminder, that means they should be:

Specific
Measurable
Achievable
Relevant
Time-based

As an example, don’t make a goal “to pay off debt.” Instead, make a goal to pay off a specific number of credit cards (like three credit card debts). Or even better, make a goal to pay off an exact amount (say, $10,000 of your debt). Having this clarity will give you a good vision for exactly what you want to achieve, and that will determine the steps you need to take to get there.

Think about Reverse Engineering Your Goal

Sometimes when you are preparing goals, it can be helpful and motivating to look at examples of what others have done.

One of the most famous examples of goal setting and achievement is the first moon landing. In 1961, President Kennedy announced the goal that America would put an astronaut on the moon by the end of the decade. At the time of this bold goal, no American had spent more than 15 minutes in space!

This was a lofty goal by all accounts, though it probably fit nicely into the SMART framework. Importantly, it was a clear goal with a set timeline. This meant that everyone working toward it—mostly the brilliant folks at NASA—could develop the steps required to reach the goal. Starting with the end result—the goal—they could work backwards and determine each piece that would need to be in place in order to be successful. They were successful, and the rest is history.

You can approach your goals like this too. Using the goal to repay $10,000 in debt is again a helpful example. First, make sure there is an end date for the goal. Let’s say it’s feasible to pay it off in one year. Then your goal would be to “pay off $10,000 in debt by the end of 2021.” What steps or sub-goals would you need to achieve this goal? Maybe it’s that $7,500 should be paid off by October, $5,000 should be paid off by July, and $2,500 should be paid by April.

That’s a simple example, but the concept can be applied to many goals. When you start with the end result, two things happen. First, you begin to visualize your success, because you are beginning with the assumption that your goal is completed. This can give you a huge psychological boost. Second, you can identify the steps that will be necessary to reach the end goal.

Put Pen to Paper

As part of your financial plan, you should write down each financial goal you have. Then, list out the various sub-goals you will need to achieve along the way. There are many different ways you could write this down to map it out. If you want to see some great examples, and access free templates, you can check out this post on goal trees from a financial independence blogger.

You will need to put more in writing, too. Just putting your goals on paper and getting organized with what you hope to accomplish probably is not enough for most people. You will also need to put your current financial situation into writing—in other words make a budget.

This is the most critical part of a financial plan, because it will reflect your day-to-day reality. Budgeting at the beginning of the year is an especially helpful exercise because it allows you to review the previous year’s expenses across all spending categories and provides the chance to plan for the upcoming year. This is the perfect opportunity to make a plan for reducing your spending. You will likely find categories that provide opportunities to make cuts and spend less than last year.

Making these cuts—and keeping up with them all year long—may even be sub-goals toward your larger financial goals. Some cuts can be made at once, like reducing a monthly bill such as when you cut out cable. Others will be ongoing cuts throughout the year, such as reducing your grocery budget. Reductions to your spending that occur time and time again throughout the year could be listed in your financial plan as weekly or monthly sub-goals, and your budget will allow you to check in frequently to see how you are doing.

There are Many Tools to Help

You can make your financial plan with literal pen and paper, or use some of the many digital tools available. The NFCC has a helpful budget planner that would be a great start. There are many sophisticated budgeting and financial planning software programs that can help, too. Think carefully before paying for such a service. While that may be helpful, it’s also a cost that will add up over time. And budgeting manually may be a better alternative because it forces you to take a more critical look at the numbers.

Whatever you decide, the important thing is to keep track of your goals, break them into sub-goals when needed, and budget each month. Taking these steps will put you well on your way to achieving your 2021 financial goals. If you need more assistance, remember that the NFCC is here to help.

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One of the keys to financial success is keeping a balanced and predictable budget. The most important categories in that budget are those that are critical to your health and safety. Most utilities fit into this category. You’ll want to ensure that you know what to expect for these costs each month. And, you will want to actively seek ways to lower your utility bills if they take up too much of your monthly budget.

How much should you pay for utilities each month? It may be better to think in terms of a percentage of your income rather than a flat dollar amount.

Budgeting by Percentages and Defining “Utilities”

Conventional wisdom has been to budget according to percentages for each major spending category. Many experts have recommended for decades that consumers should spend less than 30 percent of their gross monthly income on housing, though some give a range like 25 to 35 percent. This may go back to a government standard introduced in the 1960s. Is this still relevant today? Maybe. It certainly can be a helpful guideline, though it is far from perfect.

An example percentage-based budget. Source: Michigan State University Extension.

A popular new budgeting approach is to use the 50/20/30 budget. In this model, housing is folded into your “basic needs,” which should be 50 percent of your income or less. This model may better reflect different costs of living in different locations.

Source: NerdWallet

However, neither of these methods account for utilities specifically. The “30 percent rule” really misses the mark here. Many experts have taken the 30 percent rule and added other categories like groceries, transportation, and insurance. All the categories are assigned a percentage, and together all the percentages add up to 100 percent. But often, no percentage is assigned to utilities. So, utilities fall under “housing.” This can be a problem because many people consider them to be two different expenses and may not account for utilities when calculating how much of a mortgage or rent payment they can afford. The 50/20/30 is better at accounting for utilities because it leaves a lot of wiggle room. However, it does not set a specific range for utility costs.

If you would like a specific rule to follow, then keep your utilities under 10 percent of your gross income. Though a good rule of thumb, ten percent is still pretty high, so think of it as a ceiling and keep the costs as low as you reasonably can. You should review the average monthly costs for common utilities in your area and budget for those amounts or more. Importantly, you must remember that your specific location and the square footage of your living space will determine how much you pay. But, knowing the average can be very useful to ensure that what you are paying is reasonable.

If you use the traditional budget percentages, remember that your 10 percent utilities budget is part of your housing budget. If you use 10 percent on utilities, that would leave only around 20 percent for your other housing costs. If you use the 50/20/30 budget, then the 10 percent is part of your 50 percent “needs” budget.

It might sound easy to keep utility costs under 10 percent of your income, but it is not easy for everyone. The less income you have, the higher the percentage of your budget you will devote to energy. The Natural Resources Defense Council reported in 2016 that low-income consumers were at risk of facing burdensome energy costs. That group had a “median energy burden” of 7.2 percent, meaning that a median of 7.2 percent of their monthly budget went toward energy costs.

This study only looked at “energy” expenses. It excluded water and secondary utilities like trash pickup and cable services. Therefore, once you add these additional expenses, it is easy to see how the costs could exceed 10 percent. Careful planning is important to limit your utility spending, especially when accounting for all utilities.

Budgeting for Your Total Utility Cost

To get an idea of what you should be paying for utilities, review your monthly bills, and cross reference them with these findings. You can also check with your local utility providers for more specific information, or consult with a realtor, neighbor, or anyone else who knows the specifics of your neighborhood.

Electricity

According to the most recent data from the U.S. Energy Information Administration, the average U.S. electric bill is $115.49. You can review all the data and look up the average for your state.

Water and Wastewater

A leading water-focused research group published a study last year, finding that the average bill in the U.S. for water and wastewater was $104 total.

Gas

Rocket Mortgage reported in 2017 that the average monthly gas bill was just above $55. It also reported state-by-state data that you can review.

Garbage Removal

The utilities listed so far are all necessities. Some homes may not use gas, but those that do rely on it for critical tasks like heat or cooking. There are other utilities that are very nice to have, but don’t quite rise to the level of being necessities.

One of those is garbage removal. You can probably expect to pay between $20 and $50 for garbage removal in most cases.

Phone, cable and Internet

Phone, cable and Internet costs are also not necessary and can vary widely. Unlike electricity, which costs more as you use more, typically these services charge a flat fee. The best way to save money is to pick the most affordable services upfront. These days, there are very low-cost cell phone plans, and many people choose to skip cable and opt for a cheaper streaming service instead. For Internet, you may be able to save money by opting for a slower speed, since oftentimes the upgraded plans do not make enough difference to warrant the cost.

For a family of two adults, a conservative budget for these expenses might be around $100 per month. However, these costs could easily creep to $200, $300 or more if you do not shop around, subscribe to many services, or opt for expensive options.

Making Changes

If you need to get your utility costs under control, the two best ways are to use less and to shop around. NerdWallet has put together 15 easy ways to lower your utility bills. Most of those focus on weatherproofing, stopping leaks, and so forth. Don’t forget about negotiating and checking prices with different companies. If it has been a while since you last shopped around for utilities, it may be worth doing so again to see if you can get better pricing than you are currently paying.

Another idea would be to get a roommate who could share the costs with you, though this will not be feasible for everyone.

Recap

Utilities can add up very quickly and take a big chunk of your budget. Unfortunately, many traditional budget models do not properly account for these costs. Try to spend no more than 10 percent of your monthly income on utilities, and take simple steps to lower these costs as low as you can.

If you are struggling to pay utility bills or other bills, contact a credit counselor who can work with you to figure out your best options moving forward and do a thorough review of your budget.

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