How Do You Define Discretionary Income?

• Disposable income is the money that is available to invest, save, or spend on necessities and nonessential items after deducting income taxes.
• Discretionary income is what a household or individual has to invest, save, or spend after necessities are paid.
• Examples of necessities include the cost of housing, food, clothing, utilities, and transportation.
• The U.S. Department of Education uses your discretionary income to calculate payments for income-based repayment plans.

Disposable Income

Disposable income serves as a significant economic indicator for analyzing the overall state of the economy. It represents the net income available to households or individuals after income taxes, which can be allocated towards saving, investing, or spending. When you receive your paycheck, the amount you take home after taxes is your disposable income. By deducting all essential payments from disposable income, we arrive at discretionary income.

For instance, consider a household with an annual income of $250,000, subject to a 37% tax rate. The household’s disposable income would be calculated as $250,000 – ($250,000 x 0.37) = $157,500. This means the household has $157,500 at its disposal, which can be allocated towards necessities, luxuries, savings, and investments.

Disposable Income and the Stock Market

A substantial increase in disposable income in the United States correlates with a rise in the stock market value. This phenomenon occurs because stock valuation is positively influenced by factors such as robust job opportunities and increased consumer spending. When the demand for goods and services surges, it results in heightened production and output within the manufacturing and service industries.

Consumer spending plays a pivotal role in bolstering both the stock market and the overall gross domestic product (GDP) of the United States. As disposable income experiences an upswing, households are presented with choices on how to utilize their surplus funds. Some may opt to invest and save, such as contributing to an individual retirement account (IRA) or opening a high-interest savings account, while others may decide to increase their spending on various purchases.

Conversely, a decline in disposable income often leads to reduced consumer spending and investment activities, which can have a significant impact on the stock market. When consumers adopt a more frugal approach, it can result in decreased sales and earnings for corporations and businesses, ultimately causing stock values to slump. Consequently, the prudent financial behavior of consumers during times of lower disposable income can influence the overall performance of the stock market.

Discretionary Income

Discretionary income refers to the portion of an individual or household’s income that remains after essential expenses, such as taxes, mortgages or rent, utilities, student loans, and credit card debts, have been covered. It represents the money available for investment, savings, or non-essential spending. Discretionary income is a subset of disposable income, which means there are some similarities between the two types of income.

However, a crucial distinction lies in the fact that disposable income does not consider necessary expenses. It solely represents the funds available after taxes, which can be used for both essential needs and discretionary purposes, like leisure activities or non-essential purchases.

Discretionary Expenses vs. Non-Discretionary Expenses

Non-discretionary income encompasses the funds allocated for essential expenses, such as rent, loan payments, clothing, food, utility bills, and other typical necessities.

For instance, let’s consider an individual with an annual income of $100,000 and an income tax rate of 35%. This person’s necessary expenses, including transportation, rent, insurance, food, clothing, and others, amount to $35,000 per year. To calculate their discretionary income, we subtract taxes and necessities from their total income, which is $100,000 – ($100,000 x 0.35) – $35,000, resulting in a discretionary income of $30,000.

Discretionary income, on the other hand, is the portion of one’s income that remains after accounting for taxes and necessary expenses. This surplus income can be utilized for various purposes, such as funding vacations, contributing to retirement accounts, purchasing luxury items, or acquiring non-essential goods and services (distinguished from basic needs like food, housing, healthcare, transportation, and utilities).

In a business context, essential expenses may include employee salaries, payroll software, and shipping costs. On the other hand, discretionary expenses for a business could involve hosting holiday parties or providing special gifts for customers. These discretionary expenditures are not critical to the day-to-day operations but can enhance employee satisfaction and customer relations.

Discretionary Income Considerations for Student Loans

Understanding how your discretionary income affects your student loan debt can be advantageous when considering federal student loan programs, such as income-based repayment plans. These plans, offered by the federal government, take into account your discretionary income and provide more affordable options based on your income and family size.

There are four income-based repayment plans available:

• Revised Pay As You Earn Repayment Plan : This plan requires you to pay around 10% of your discretionary income towards your student loans.
• Pay As You Earn Repayment Plan : Similar to the REPAYE Plan, it charges approximately 10% of your discretionary income but never exceeds the amount you would pay on the 10-year standard repayment plan.
• Income-Based Repayment Plan : For new borrowers on or after July 1, 2014, this plan accounts for 10% of your discretionary income. For those with this date, the amount goes up to 15% but never exceeds the 10-year standard repayment plan amount.
• Income-Contingent Repayment Plan : This plan calculates your repayment amount based on the lesser of 20% of your discretionary income or the fixed payment you would make over 12 years, adjusted according to your income.

It’s essential to note that if your discretionary income increases, your loan payments will also increase under these plans.

When applying for a federal income-based student loan repayment plan, the calculation of discretionary income is slightly different. The required monthly payment is generally a percentage of your discretionary income, which is the difference between your adjusted gross income (AGI) and 150% of the U.S. Department of Health and Human Services (HHS) Poverty Guideline amount for your family size and state. The payments are capped at a certain percentage depending on the program, your salary, and family size.

For assistance in choosing the appropriate repayment plan, the Federal Student Aid website offers a loan simulator tool. This tool helps you navigate the process of paying back your student loans by providing a series of questions tailored to your individual situation.

How to Calculate Your Discretionary Income

Calculating your discretionary income involves the following steps:

• Start with your disposable income – the amount remaining after paying taxes.
• Next, calculate all your essential expenses, including rent or mortgage payments, utilities, loans, car payments, and food.
• Make sure to deduct any taxes that will be owed.
• Finally, whatever amount is left after covering all necessary expenses and taxes is your discretionary income. This is the amount you have available to save, spend, or invest.

Disposable Income Per Capita

Disposable income holds significant importance for financial analysts and government officials as it serves as a critical indicator for assessing a country’s economic strength. Economists closely monitor disposable income to analyze household spending and saving patterns, which, in turn, helps them make predictions about consumer behavior, living expenses, and savings habits.

The Organisation for Economic Co-operation and Development (OECD) plays a vital role in compiling economic data for 37 nations, tracking and reporting household disposable income per capita. Per capita income, a commonly used metric in economics, refers to the average amount of money earned by each individual within a specific region or nation. As of December 2020, the OECD website reported that the United States had an average household disposable income of $45,284 per capita.

Unsurprisingly, the United States stands among the top-ranking countries with the highest disposable income per capita. Additionally, other nations that make the top ten list in terms of high disposable incomes per capita include Luxembourg, Switzerland, Germany, and Australia. This data provides valuable insights into the wealth and financial stability of these countries’ households.

What Are Examples of Discretionary Income?

Discretionary income refers to the funds that remain at your disposal after deducting taxes and essential living expenses. It encompasses income from various sources, such as paychecks, social security, or any other earnings. This surplus income can be utilized for various non-essential expenses and activities, such as dining out, watching a movie, purchasing tickets to a show, or going on vacation. Essentially, discretionary income provides the financial freedom to indulge in leisure and recreational activities beyond essential needs.

What Is the Difference Between Discretionary and Disposable Income?

Disposable income signifies the portion of your earnings available for both spending and saving once income taxes have been settled. On the other hand, discretionary income pertains to the funds an individual or family possesses for investment, savings, or non-essential expenditures after covering taxes and necessary expenses. It’s important to note that discretionary income is derived from your disposable income, as it represents the surplus amount after taking care of tax obligations.

How Do You Figure Out Your Discretionary Income?

Discretionary income is directly linked to and derived from your disposable income, serving as the funds available to cover non-essential expenditures.

To illustrate this, consider your disposable income, which represents the amount of money remaining in your paycheck after taxes. Next, subtract all necessary expenses such as rent or housing payments, student loans, utilities, and food costs. Whatever surplus remains after these essential expenses have been accounted for becomes your discretionary income, which you can then utilize for spending, saving, or investing as you see fit.

The Bottom Line

Disposable income and discretionary income are both important metrics used by economists to analyze consumer spending patterns. Discretionary income is essentially a subset of disposable income, representing the funds available for covering both essential and non-essential expenses. After accounting for all living expenses, whatever money remains for saving, investing, or spending constitutes your discretionary income. Any decrease in your disposable income will consequently result in reduced discretionary income, potentially impacting financial markets and the overall economy.

When applying for federal student loan income-repayment plans, the U.S. government calculates your discretionary income as the gross after-tax income for the year minus 150% of the poverty guidelines based on your state and family size. Additionally, any fluctuations in your income are taken into consideration during this calculation process. This ensures that your repayment plan aligns with your current financial situation, making it more manageable for borrowers.