There’s no doubt that savings are important, but many households in the US can struggle to save. A good savings account can have interest rates that help you make the most of your savings, and you might be surprised to see interest mentioned on your tax forms. Interest is taxable, which is why savings should be treated as another type of net income. But what is net income and how does it relate to savings?
1. What is Net Income?
Before you can start treating your savings as part of your net income, you’ll need to know what net income is. Net income is gross income minus taxes and expenses. So what’s gross income? Gross income is the total amount of money you make. What does that look like in real life? Here are three examples of gross income and net income in real-world situations.
Mark’s Gross Income and Net Income
Mark works as a mechanic at an auto shop. He makes $18.50 an hour and works 40 hours a week. Mark’s gross income is $740 a week. That adds up to $38,480 a year. However, Mark’s employer deducts his taxes automatically. After federal income taxes and social security, let’s say Mark brings home $687 a week ($35,752 a year).
Since Mark works for the auto shop, he doesn’t need to pay for his own tools, advertising, or space. This means he has no other expenses. Mark’s net income is $35,752.
Emma’s Gross Income and Net Income
Emma is Mark’s wife. She started her own home Bookkeeping business with bookkeepers.com. She had a great first year and invoiced for $30,000. Emma’s gross income is $30,000. She paid 20% of what she made in quarterly tax payments, so she brought home $24,000.
However, since Emma is running her own business, she had expenses, too. These included software, traveling to conferences and networking events, and her work computer. Emma’s expenses added up to about $1,200 this year. After taxes and business expenses, Emma’s net income is $22,800.
Mark and Emma’s Gross and Net Income
When you add it together, Mark and Emma had a gross income of $68,480. After taxes and expenses, their net income was a total of $58,552. However, their jobs aren’t the only forms of income Mark and Emma have.
Mark and Emma want to buy a home and start a family in the future, so they opened a high-interest savings account with Aspiration a couple of years ago. This year, they finally met their savings goal of $10,000. They’ve met all the requirements to get the 5.00% APY interest rate, so they were paid $500 in interest. This $500 in savings should be treated as part of their gross income.
Mark and Emma will have to pay taxes on the $500 they were paid in interest, but not on the full $10,000 they saved. After they pay taxes, they have $450 in interest. This extra $450 in savings should be treated as another type of net income.
2. An Interesting Problem
Like Mark and Emma, you might be surprised or disappointed to learn that you have to pay taxes on interest. After learning that, the question is: are there savings accounts you don’t have to pay taxes on?
Kind of. While there are tax-exempt savings accounts, there’s a catch to them. Each kind of account has its own special rules. Across the board, though, tax-exempt accounts can only be used for specific things. This means that you can’t pull from a tax-exempt account to fix your car or go on vacation.
It’s also important to remember that you will have to pay taxes on your income at some point. Some accounts, like IRAs, just defer tax payments until you use the money. Others, like education or health savings accounts, you pay income taxes on and then put the money into the account.
IRAs are a kind of retirement savings account. Many employers will match your IRA contributions, and some require a percentage of your pay to go into an IRA account each paycheck. IRAs do not have interest rates and they don’t change to account for inflation. However, this kind of savings should be treated as part of your gross income for the future.
Health Spending Accounts (HSAs) are used for medical costs, and they’re usually set up through your employer. These accounts do have interest rates, but they can also be subjected to a tax penalty if you use the funds before the age of 65 for nonmedical expenses. You’ll be making payments into your account before income taxes. Since these accounts can be used tax-free for medical costs, HSA savings should be treated as another type of net income.
A 529 account is a savings account used for college expenses. The specific tax benefits of this kind of savings account can vary between states, so check your local regulations. These kinds of savings should be treated as another type of net income or gross income, depending on your state.
3. Making the Most of Your Savings
There are tons of different ways to save money. You can pick high-interest accounts, tax-benefitted accounts, or both. The best way to get the most of your savings is to budget for a little money in different places.
Let’s face it, you’ll have to spend money on retirement, healthcare, and education at some point. Use your gross income to put money into those accounts. The rest of your savings are coming from your net income, and every cent is working as hard as possible.
Taxes on interest from your savings account can be frustrating, but the interest compounding over time is worth it. Your savings can be a big part of your net income, even when the interest takes a tax hit.
Mark and Emma’s savings account is a great example. After taxes, they have $10,450. That amount will continue to accrue interest next year, so even being taxed, their savings are growing!
Undervaluing your savings can seem easy when you’re first getting started, but stick with it. A little money in savings can turn into a lot of money in savings when you keep working at it. The bigger your investment, the bigger the bonus, which is why your savings should be treated as another type of net income, even if it doesn’t seem like much yet.