Takeaways
- Discretionary income funds savings, investing, travel, and entertainment.
- The higher your discretionary income, the greater the odds of achieving your money goals.
- Don’t confuse discretionary income and disposable income.
- Paying off debts increases your discretionary income in the long run
- Discretionary income is an economic proxy for financial well-being.
What is Discretionary Income?
Discretionary income is the amount of money left over after you have paid all your living necessities – taxes, housing, and groceries. Economists use discretionary income to gauge how the economy is performing. Less discretionary income could mean that you might have high debt payments for student loans, credit cards, or auto loans.
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Discretionary income helps fund savings, investments, travel, and entertainment. Discretionary income can be measured on an individual or household basis. Personal finance experts recommend keeping your discretionary income high to fuel wealth-generating activities such as saving in a high-yield savings account and investing in the stock market. The larger the percentage of your discretionary income saved for the future, the more financially prepared you will become.
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Because debt payments erode discretionary income, the lower your debt burden, the higher your potential discretionary income. Finance professionals argue that becoming debt-free will spur your discretionary income savings. Plus, a high discretionary income can fuel personal passions. For example, a high discretionary income traveler could fund regular trips abroad.
Discretionary Income vs. Disposable Income
People often interchange disposable income and discretionary income, but there is a critical difference. Discretionary income is derived from disposable income. Disposable income is your total income before taxes minus your tax obligation, while your discretionary income is your disposable income minus your necessary living expenses.
Income Formulas:
Disposable Income = Taxable Income – Taxes
Discretionary Income = Disposable Income – Necessities
Budget with Discretionary Income
Effective budgeting strategies are designed to increase the amount of discretionary income flowing to high-impact areas of spending. Your discretionary spending should align with your short-term and long-term financial goals. For example, if you have high levels of credit card debt and want to eliminate your credit card debt, you should hone in on your spending to eliminate debt.
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There are even specific budgeting strategies that set concrete allocation percentages. The 50/30/20 budget allocates spending 50% of your monthly budget on necessities like rent, groceries, and insurance. Then 30% is allocated to expenses you want, such as going out to eat and other entertainment activities, and 20% is allocated to saving, investing, and paying off debt. How you treat your discretionary income directly impacts your day-to-day life.
Student Loan Repayments
Student loan income-driven repayment plans use discretionary income to calculate the amount of required debt payments. However, in income-driven repayment plans your discretionary income is calculated as your income less a multiplier of the poverty line.
For example, according to the Federal Student Aid, an Office of the U.S. Department of Education, for the Income-Based Repayment Plan, Pay As You Earn Repayment Plan and loan rehabilitation, discretionary income is defined as the difference between your annual income and 150% of the poverty guideline for your family size and state of residence1.
However, for the Income-Contingent Repayment Plan, discretionary income is defined as the difference between your annual income and 100% of the poverty guideline for your family size and state of residence.
As you can see, discretionary income definitions can vary based on income-driven repayment plans. As a result, your payments could vary from zero to thousands of dollars, depending on your income level.
Smart Summary
A high discretionary income is a marker of being able to reduce debt and save quickly. Aiming for a healthy discretionary income will only allow you to spend more on things you enjoy – shoes, clothes, travel, and entertainment – but it will give you a sense of a stable financial buffer. Thoughtful spending of discretionary income can set you up for a life of financial success and is a smart money move.
Frequently Asked Questions
Paying off your debt, like credit cards, student loans, and car notes is an efficient way to increase your discretionary income.
Increase your earnings quickly by finding the best side hustle. Check out our guide for 12 ideas on how to earn money in less than an hour.
Disposable income does matter. Reducing your tax liability can improve your disposable income. Different types of income are taxed at different rates. For example, passive income is treated differently than ordinary income. These differences have massive financial implications, with some putting more money back into your pocket.
Many personal finance experts argue that if you have an emergency and slush fund established, you should move on to investing. Opening an online brokerage account and investing in stocks, mutual funds, and ETFs is terrific for beginner investors.
