Both individuals and businesses are required to pay taxes on their earnings. The amount of taxes each is required to pay is calculated based on the income they receive. In most cases, a tax rate schedule is used to calculate the amount of tax due from individuals and corporations.
The tax amount due is what sets the profit or income before tax apart from after-tax income. The income before tax is how much an individual receives for the work they perform. In other words, it is their paycheck or hourly wage multiplied by the number of hours worked, which is better known as gross wages. When it comes to a business, income before tax is nothing more than the total revenue (money customers pay) less expenses.
So, what is after-tax income? It is not hard to guess the meaning of this term. It simply represents the taxable income with less taxes. What exactly is taxable income? It is the income minus the items that are not taxed. For businesses, these items include operating costs, depreciation expenses, and interest on loans.
You can also think of it as the income that is left in the hands of an individual or business after they also take into account the money the IRS will take from them.
After-tax income vs Net profit after tax
You might come across a similar term – net profit after tax. What is the difference between after-tax income and this concept? The difference comes from the fact that net profit after tax term is used by businesses rather than individuals, but in general, it means the same thing.
Net profit after tax refers to the total amount a business earns after all tax deductions have taken place. It is also simply known as net profit or net income. The “after-tax” is added to make it clear that it is a net income that not only took into account all the dividend payments and expenses but also the tax expense.
Both after-tax income and net profit after tax are important measures businesses and individuals calculate to see how much money they have at their disposal, whether it is to meet their living needs (and wants) or to reinvest back into the business and use for other business activities.
Calculating after-tax income
Given the definition above, the amount of after-tax income is something every business owner and individual should look into. The concept of calculation is very similar for individuals and businesses. Once you know the amount of taxes owed, simply subtract this number from the gross income. Let’s say your yearly paycheck is $58,000, and you are required to pay 12% tax, which would be $6,960. Therefore, your after-tax income is going to be $58,000 – $6,960 or $51,040.
If your business is not a pass-through entity, where business income is treated as the personal income of the owners, then you would need to pay taxes on the income it generates. Accordingly, you will also come across the term after-tax income. Typically, it is the bottom line of the Income statement presented by the corporation to the public. You would calculate it similarly, but instead of gross income, business owners use net income value to calculate their tax liability.
Let’s apply what we have learned and see what the after-tax income would be for a company with the following bookkeeping data:
- Sales: 15,000 units at $8 per unit
- Variable cost: $4 per unit
- Fixed cost: $20,000
- Tax rate: 10%.
As you can see, we are not given net income. However, we can easily calculate it ourselves. First, we do a little math and get the totals for each line item. For sales, we have 15,000 units sold at $8 per unit, so the company received $120,000 from sales. Then, we need to take into account that it had to pay $60,000 (15,000 units x $4 per unit) in variable costs and $20,000 in fixed costs. So, its income before taxes is $40,000.
To calculate the amount of taxes it owes, we need to multiply the income we arrived at by the tax rate. This company’s tax liability is $4,000. The final step in our calculation is to subtract the $4,000 from $40,000. We arrive at $36,000 after-tax income.
Retirement Contributions – Pre-tax vs Post-tax
Many individuals try to take advantage of pre-tax contributions, like a 401(k) and 403(b). These are some of the ways to save for retirement while also reducing the individual’s taxable income and, ultimately, how much taxes are owed on the annual basis. This is how using pre-tax contributions can be of value in a nutshell.
Participating in your employer’s contribution plan is a convenient way to save for retirement. Some people, though, worry that they end up taking home much less. However, there is good news. Contributing to your plan reduces your pay by less than you think.
Pre-tax contributions are deductions that take place before individuals pay taxes. They are removed from the earnings right before any taxes are being calculated. This way not only the after-tax income is increased but it also reduces the taxes you pay.
To give an example, you are making $4,000 in gross pay each month and your federal tax rate is 20%. If you make no retirement plan contributions, your taxable income stays at $4,000, so your federal tax obligation would be $800. This means you are left with $3,200 in your pocket.
Now, let’s say you decide to contribute 5% of your pay or $200 to your retirement plan. It would reduce your taxable income to $3,800. Thus, when you calculate your after-tax income, you will see that even though you are left with $3,040 (compared to 3,200), you paid $760 in taxes (compared to $800) and contributed $200 towards your retirement. To sum it up, you have $200 in your retirement plan plus $3,040 in your pocket when making contributions, as opposed to $3,200 of after-tax income when not making the contributions. Of course, many other factors should be taken into account when deciding whether pre-tax or post-tax contributions are the best choice for a particular individual, but this is one of them.