The “money comes, money goes” way of looking at things can only take you so far. Breaking out of this survival mindset is the first step on the path to financial success, but there are many other simple but practical things that you can do to get ahead in life. One of them is keeping track of the income you are making. But to do that, you first need to understand what income is and what are the different types.
This article will try to help you do just that. Learn all about the difference between gross and net income and how to calculate your taxable income here.
What is income?
The word “income” dates back to around 1300 CE. At the time, it meant arrival or entrance. Then, around 1600 CE, the term officially entered the English language. It assumed the meaning “that which comes in as payment for work or business” during this time.
Today, income refers to the money that individuals earn in exchange for labor and goods and services.
In business, revenue, which is considered a type of income, is categorized under several heads like income from operations, investing activities, and financing activities. But in personal finance, the primary source of income is either wages or salary. Secondary sources of income include interest, dividend income, and rent from house property, among others.
Types of income
Income can be classified into three different types based on the kind of source.
1. Active income
This type of income is the money you earn through your regular job or in return for your services. People usually depend on this to meet their daily expenses.
For an employed person, this would mean salary or wages. On the other hand, commissions or business profits are considered active income for self-employed professionals.
2. Passive income
Passive income is the money that you earn with minimal effort and without getting actively involved beyond the minimum. For example, rental income, income from dividends, interest, royalties, and so on.
To generate passive income, you need to make significant capital investments. It also takes time to grow and maintain profit. For instance, to generate significant passive income from dividend income, you need to consistently invest in stocks to build a sizable portfolio and reinvest profits. Learn more about how to earn a passive income here.
3. Portfolio income
This refers to the capital gains from investments in stocks, real estate, etc. Capital gains are the profit generated from the purchase of an asset at a lower price and selling it at a higher price. Unlike passive income, portfolio income only includes the capital gains from investment, not dividend income or interest received from it.
For example, if you buy a stock at ₹100, and sell it after two years at ₹350. The profit of ₹250 is the capital gain.
What is gross income?
The word gross in finance means the total amount before tax and interest deduction. Gross income, therefore, refers to the total income earned during a specific time period before subtracting any costs like interest expenses, taxes, contributions to retirement accounts, and other expenses.
It includes all forms of income, active, passive, and portfolio income.
What is net income?
Net income refers to the total income earned during a specified time period after deducting all the necessary expenses like regular investments, loan repayments, and tax payments. It is the income left in hand after making all these payments.
For income tax calculation, the calculation is based on gross income. After the tax is deducted from investment income and any loan repayment money is taken out, the remaining gross income is again eligible for tax deductions. Net income is the amount left over after all these tax deductions.
To put it in a mathematical form that you can use:
Net income = Gross income – (investments + loan repayments + tax deductions)
What is annual income?
Annual income is the amount of money you make during one fiscal year—that is, the period from April to March in India.
This type of income thus includes all forms of income—active, passive, and portfolio income—during a financial year.
How to calculate annual income?
If you are a salaried person, you could calculate your annual income in the following way. You could multiply your gross monthly income by the number of times you have received that amount during a fiscal year. That is:
Annual salaried income = Gross monthly salary x Number of months you have earned the salary
For example, suppose your monthly income from salary is ₹50,000, and you have worked for a period of 7 months during the fiscal year. In such a case, your annual income from salary will be ₹3,50,000.
Your annual income should include everything from salary to bonuses and other monetary benefits. The dividend income is not included in the calculation of annual income because it is not fixed but should be added while calculating your net income.
How is taxable income calculated?
In India, as per the Income Tax Act, 1961, an individual’s income is divided into five subheads:
- Income from salary includes basic wages, salary, advance salary, gratuity, perquisites, and annual bonuses.
- Income from house property is the rent received from letting out your non-commercial residential property.
- Income from profits of business includes all the income and profits earned from one’s association with a business.
- Income from capital assets/ investments is the profit earned from the transfer or selling of capital assets held as investments. For example, profit from the sale of equity stocks, or mutual funds.
- Income from other sources includes all the income that is not categorized under the four subheads mentioned above. It includes interest income from bank deposits, lottery, gambling, monetary rewards received from winning any sports events, and so on.
To calculate taxable income, identify all your income sources and carefully categorize them as per the income subheads mentioned above. The total income earned under the five income sources will be your total taxable income.
Now, coming to the tax deductions. There are many investments or expenses that you can use to claim deductions from taxable income under different sections. Look up the income tax law in your jurisdiction to see what they are. If you have made any such investments, make sure to deduct them from your taxable income. That will help keep more of your income in your hands.
Income is the steering wheel that keeps your financial life in motion. As it is one of the most important parts of your life, learning to manage it better will take you a long way. While we hope that this article has helped you do that to some extent, you would also do well to learn more about:
What are the types of income?
The types of income can vary, but common categories include earned income, passive income, investment income, and portfolio income.
What is the difference between earned income and unearned income?
Earned income refers to income earned through active participation in work or business activities, such as wages, salaries, or self-employment earnings. Unearned income, on the other hand, is income generated from sources other than work or active participation, such as interest, dividends, rental income, or capital gains.
What is disposable income?
Disposable income refers to the amount of money that individuals or households have available after deducting taxes and essential expenses, which can be spent or saved at their discretion.
What is the difference between gross income and net income?
Gross income is the total income earned before any deductions or taxes are applied. Net income, on the other hand, is the amount of income remaining after deductions such as taxes, expenses, and contributions have been subtracted. Net income is the actual income received by an individual or business.