After taxes and necessary day-to-day expenses, the amount of income left over is referred to as discretionary income. It’s not to be confused with disposable income, which is the money left over after taxes have been deducted.
Discretionary spending is one of the indices of a healthy economy. People only spend money on things like travel, movies, and consumer electronics if they have the funds to do so.
In this guide, we’ll answer the question, what is discretionary income and also every other thing you need to know about it.
What Is Discretionary Income?
Discretionary income can be defined as the income you have left to spend, save, or invest after catering for taxes and other essentials such as rent or mortgage, utilities, food, and credit card bills.
It is usually less than both total income and disposable income because it’s income you can use at your discretion.
Additionally, your discretionary income can be used to take care of vacations, investments into retirement accounts, luxury items, or anything good or service that is not necessary, like housing, food, transportation to a job, or medical care.
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How Does Discretionary Income Work?
Discretionary income is important to most people since it is the amount of money remaining in your budget that you can spend or save.
You’ll put the rest of your money toward things like retirement savings, debt payments, dining out, entertainment, and whatever else you want to do with it.
Discretionary income, on the other hand, has a more definite meaning in some circumstances. If you have federal student loans and pick an income-driven repayment plan, for example, your monthly loan payments will be determined by your discretionary income.
You must contribute a proportion of your discretionary income to these programs, which varies based on the plan.
How Discretionary Income Impacts Your Budget
According to bankrate, discretionary income can be a barometer that shows how well you are doing financially. If you are left with something after you’ve catered for your necessities, it is easier to save money, go on a vacation or probably try skydiving.
This entails, discretionary income as a measure of your income and expenditure lifestyle. If you find yourself short of cash as a result of increased expenses, you need to watch it.
Consider revising or developing a budget if you don’t already have one to save even more money or limit other spending. A budgeting tool might also assist you in gaining a new perspective on how you spend your money.
Practical Example of Discretionary Income
Discretionary income is neither total income nor disposable income because it’s income you can use at your discretion. Since everyone has to pay for certain essentials, such as food and housing, you have to subtract those costs to determine your discretionary income.
A woman receives an annual gross (pre-tax) income of $50,000. Shee pays a 30% tax rate over the year and incurs essential expenses of $2,000/month for bills, rent, groceries, etc. What is her disposable income?
The amount of taxes paid is calculated as pre-tax income multiplied by the tax rate, as shown below:
After taxes, the amount of disposable income is $35,000 ($50,000 – $15,000).
What is her discretionary income?
The amount spent on essential expenses over the year is the monthly expenses multiplied by twelve months in the year.
- $2,000 x 12 months = $24,000
After taxes and essential expenses, the discretionary income is $11,000.
How to Calculate Discretionary Income
The formula for discretionary income is:
- Discretionary Income = Gross Income – Taxes – Necessary Expenses
When calculating your discretionary income, it’s best you start with your disposable income, which is the money left over after taxes are deducted.
After that, add up and compute all of your expenses, including rent or a mortgage, utilities, loans, auto payments, and food. Once you’ve paid for all of those things, your discretionary income is whatever money you have leftover to save, spend, or invest.
For students, your discretionary income is computed a little differently when applying for a federal income-based student loan repayment plan.
According to the Federal Student Aid Office, your compulsory monthly contribution under REPAY, IBR, and PAYE programs is normally a percentage of your discretionary income and is tallied as such.
“The difference between your adjusted gross income (AGI) and 150 percent of the US Department of Health and Human Services (HHS) Poverty Guideline amount for your family size and state is your discretionary income for all three plans.”
In addition, depending on the program, your wage, and the size of your family, your payments are capped at a certain proportion.
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Discretionary Income vs. Disposable Income
I’m sure you must have heard of disposable income. Well, if you’ve not, disposable income is a person’s pay that is used to cater to essential and non-essential needs.
The terms discretionary income and disposable income are often used conversely. However, they are different types of income.
While disposable income can be said to be what is left over after taxes and is available to spend save or invest, discretionary income is what is left after paying for rent/mortgage, transportation, food, utilities, insurance, and other critical bills.
Consider this scenario:
After your employer deducts taxes from your paycheck, your disposable income is the money you have available to spend. It does not take into account any important costs, such as rent or auto payments.
On the other hand, discretionary income is your remaining money available after subtracting necessary bills from your income.
Why You Should Have Discretionary Income
When creating a budget, knowing your discretionary earnings is critical since it allows you to determine how much money you have left. When there is a change in earnings, your discretionary income is the most affected.
Your core expenses are fairly predictable. The monthly payment on your mortgage, for example, will never change unless you relocate or refinance.
Whether you get a raise at work or are fired from your job, you will still have to make your mortgage payment.
Your discretionary funds, on the other hand, are more adaptable; they can rise if you get a raise. Your fixed expenses are the same as they were on your former pay, but you have more money to spend now.
In the opposite case, if you lose your job, your disposable income decreases. As a matter of fact, you may not have enough money left after deducting your needs from your emergency savings to spend on other things.
Do Lenders Consider Discretionary Income?
Lenders often consider discretionary income if you have student loan payments. If you are having difficulty with federal student loan debt, your lender will assist you to craft an income-driven repayment plan (IDR plan).
According to meettally, the student loan repayment plan will limit your monthly payment to a certain percentage of your discretionary income. The limits can be:
The Department of Education calculates discretionary income based on your adjusted gross income (AGI), location, and family size.
Your federal student assistance payback terms are ultimately determined by the poverty level in your location.
The U.S. Department of Education offers four repayment options to student loan borrowers:
- Revised Pay As You Earn (REPAYE)
- Pay As You Earn (PAYE)
- Income-Based Repayment Plan (IBR)
- Income-Contingent Repayment Plan (ICR)
The first three options describe discretionary income as the distinction between your AGI and 150% of the federal poverty guideline for your family size and state of residence.
The fourth option sees discretionary income as the difference between your AGI and 100% of the poverty line.
So, based on these plans, you can see that lenders often consider your discretionary income as your monthly repayment on your federal student loan will be no more than 20% of your discretionary funds.
These standard repayment plans are capable of reducing your interest rate. If your income is at the barest, you could be granted student loan forgiveness, and your monthly payment will be $0.
FAQs on Discretionary Income
Discretionary income can be defined as the income you have left to spend, save, or invest after catering for taxes and for other essentials such as rent or mortgage, utilities, food, and credit card bills.
The formula for calculating discretionary Income = Gross Income – Taxes – Necessary Expenses
Some common discretionary items are:
- Vacations and travel expenses.
- Alcohol and tobacco.
- Restaurants and other entertainment-related expenses.
- Coffee and specialty beverages.
- Hobby and sports-related expenses, such as crafting, sewing, and gym memberships.
You can use the discretionary income for “extra” things, like entertainment, vacation, savings, and investments.
An awesome amount of discretionary income entails you can cover all your necessities and still have money left over to invest, save, or spend.
Knowing what discretionary income is can help you improve your financial condition significantly.
Always ensure you track your discretionary income as it will help you make the right decision on what to spend on or how much to save.