Most people find the world of personal finance complicated enough without learning new vocabulary terms like discretionary income and disposable income. Less helpful is the fact that many people use them interchangeably. But they’re not one in the same. And that makes it even more confusing when you’re trying to make a plan to pay down debt or save for your future.
Sometimes, it even seems like the financial industry is trying to make it as complicated as possible. However, we’ll show what these terms mean and how they affect you, as it is essential that you understand them before buying a home, saving for retirement, or paying down debt. And its just as important to know what they are not. Most importantly, it’s vital for you to understand how to calculate these when planning your budget.
Understanding how to calculate your discretionary income provides those all-important numbers that you need to create a financial plan. The good news is, it’s not as complicated as it may sound at first.
What Is Discretionary Income?
Simply put, your discretionary income in the amount of money you have left over after paying your taxes and necessary expenses. The term “discretionary” means it’s up to your discretion to decide how you use these funds.
Many Americans find the amount of discretionary income they have to work with is decreasing as the cost of goods and services rises, and wages and salaries fail to increase to keep up with them.
What is disposable income?
The term “disposable income” can be a bit misleading. Your disposable income is the amount of money you have after you pay all your income taxes. Although it may seem like there’s plenty of money in your net, after-tax wages, it doesn’t seem like there is anything “disposable” about them. Most of us also have to pay for housing, food, transportation, and other necessities.
What’s the difference between discretionary income and disposable income?
Basically, your discretionary income is in fact, discretionary. After you’ve paid your taxes and your bills, it’s money left that you can save, spend, or invest any way you choose. Disposable income, on the other hand, is just your income after taxes.
Why do you need to know your discretionary income?
This term will come up frequently when you’re budgeting or creating any financial plan. If you carry student loans, this number may determine how much you need to pay on that debt every month.
The reason it’s important to understand what your discretionary income is because that most Americans don’t have much immediate control over their expenses. It’s true that you can often cut back on costs, but most monthly bills aren’t that flexible.
For example, you could increase your discretionary income by finding a cheaper apartment to rent, but you may still have another six months on your lease. This means the money you spend on rent, at least for the next six months, isn’t really up to you to decide. Also, if you have children, there’s not as much room for adjustment in the food budget if you want to keep them well nourished. In another example, you could trade in your car for an older model that costs less. However, if your income depends on reliable transportation, that expense may be necessary for earning a living.
This is why it’s important to distinguish your disposable (take-home) income from your discretionary income. Your discretionary income is the money you can make immediate decisions about how to spend.
Why You Need to Know Your Discretionary Income
There are several scenarios when it’s helpful to know precisely how much money you have to work with when making plans for your future. If you’ve decided to start increasing your savings for retirement, you’ll need to know exactly how much you can afford to invest. Although we all need to plan for retirement, we also want to make sure we have money for immediate needs.
Many Americans are jumping on the debt-free train. They work hard to cut down on the amount of money they owe to creditors. To make a debt payoff plan, you’ll need to know your expenses. You’ll also need to know how much money you have to pay down any loans you have. Being debt free is a fantastic feeling. And knowing your discretionary income to a penny can make it happen that much faster.
If you’re carrying student loans and having a hard time making the payments, you may be eligible for an adjustment program. A significant number of former students are finding it nearly impossible to get out of student debt. They can’t move forward to buy homes and invest or save. So many young people were encouraged to get college degrees over the last 30 years. However, the job market hasn’t accommodated them. And it certainly hasn’t delivered on the substantial salaries promised for receiving a college education. Because of this, the federal government has launched several student loan repayment programs. They base your monthly repayment on current income and most importantly, discretionary income.
Student Debt and Discretionary Income
The Office of the U.S. Department of Education has launched four separate income-driven repayment plans that base your loan payment on your income and the size of your family. Most of these programs may extend the length of your loan repayment. However, they’ll also allow you to raise a family, purchase a home, and invest in retirement by lowering your monthly payment. They calculate your monthly as a percentage of your discretionary income. Usually, this is about 10 percent. However, this percentage varies, depending on the program.
Revised Pay As You Earn Repayment Plan (REPAYE Plan)
In this program, you’ll pay about 10 percent of your discretionary income. The plan spreads the payments over 20 years for undergraduate work and 25 years for graduate studies.
Pay As You Earn Repayment Plan (PAYE Plan)
In this plan, your payment will be approximately 10 percent of your discretionary income, but it will never go higher than the standard 10-year repayment plan. The length of the PAYE plan is 20 years.
Income-Based Repayment Plan (IBR Plan)
If you took your student loan out after July 1, 2014, you’d be making payments for 20 years. They will calculate your payments at about 10 percent of your discretionary income. However, even if your income increases, the amount will not go higher than that of the standard 10-year plan. If you took your loans before that date, your payments would be 15 percent of your discretionary income with a payment plan of 25 years.
Income-Contingent Repayment Plan (ICR Plan)
If you enter the ICR plan, you’ll make payments over 25 years. In this scenario, your payments equal 20 percent of your discretionary income or the standard amount for a fixed-rate, 12-year plan.
One of the high points of these plans is that the repayment length includes periods of deferment for economic hardship. And the program forgives the remaining balance of your if not paid by the end of the 20-year or 25-year term. Note that these are only for federal student loans, however.
The Federal Student Aid website has a handy tool for helping you estimate your payments under one of these programs.
How to Figure Your Discretionary Income
There are two different methods for calculating your Discretionary Income, and which method you use depends on why you’re making the calculation. The Department of Education has a simple formula for determining this number for student loan repayment plans. If you need to calculate this number for other reasons, it can be a bit more complicated.
Figuring Discretionary Income for Student Loan Repayment Plans
To complete the formula for determining your discretionary income before applying for a repayment plan, you’ll need some information. Get your adjusted gross income from your most recent tax turn, the number of dependents filed on that return, and the poverty guidelines for the state where you live. A poverty guideline is a number adjusted according to the economy that determines the income that meets the official “poverty level.” The guide is the same for all 48 of the contiguous states. But if you live in Alaska or Hawaii where the cost of living is higher, you’ll need to make sure you have the right number when checking the chart.
Determine your adjusted gross income by looking at your most recent tax return. If you filed a Form 1040, you’d find the correct number on line 37. Then, determine your “family size” by the total individuals you filed on that return, including yourself, your spouse, and any dependents.
You can find the poverty guideline number on the Health & Human Services website. Simply match the number of family members filed on your most recent income tax statement to the income level.
The formula is simple:
Your adjusted gross income – (Poverty Guideline x 150 percent) = Discretionary Income
By knowing this number, you can estimate how much your payment would be using one of these programs. In this way, you can make financial plans for your future, including budgeting a home purchase, buying a car, or saving for retirement.
Calculating Discretionary Income for Saving and Investing
There’s an old adage about personal savings that goes: “Pay yourself first.” You could interpret that as permission to spend money on new electronics, clothes, or take vacations. And while you want to reward yourself for your hard work, that’s not what it means. Whatever else you spend money on, make sure you put some aside for your future. After all, the future and the economy are uncertain at the best of times. So, take advantage of windfalls and extra income to save and invest.
When creating a budget, it’s crucial to plan ahead for every contingency. It’s great to commit to saving as much as possible in your IRA. However, if that means you don’t have the cash to repair your home or your vehicle, you’ll find yourself stuck. You won’t have the option of accessing that money without paying a penalty until you’re over 55.
Creating a zero-based budget
You want to make sure that you’re able to invest for your future and still meet all your current needs. That’s why it’s important to make a solid plan for every dollar you earn. One way to do that is to create a zero-based budget. By anticipating every scenario in a comprehensive plan, you’ll be able to identify the amount you should save or invest.
A zero-based budget allows you to determine ahead of time how you will spend your income. By taking your monthly net pay, subtracting your usual expenses, you’ll identify the amount of your discretionary income. Take the next step by planning for purchases and expenses that don’t occur every month. For example, if you buy new school clothes for your children every August and every January, put aside money for these expenses every month. In that way, you’ll be ready for a great sale on kids’ clothes.
Other non-regular expenditures include auto repairs. Calculate how much you normally spend over the year to keep your car in top shape. Then set aside a monthly amount to accumulate until it’s time for that new set of tires.
A zero-based budget will give you total control over your discretionary income. You’ll know how to put it to work for you, instead of burning a hole in your pocket. It will also ensure that you have the funds for any emergency that comes up.
Discretionary Income As Your Ticket to Financial Empowerment
We may not have much immediate control over our income and the cost of living. But, the one thing we all have complete control over is our discretionary income. It is, by definition, at our discretion. And that’s a fascinating concept.
That means that it’s up to you what to do with your money. And every dollar you spend is an investment. It may be an investment in creating a memory that will last a lifetime by spending it on vacation. You could call it an investment in better health by purchasing more fruits and vegetables. It could also be an investment in a new home when you save for the down payment.
The secret is to decide how to best invest your discretionary income before circumstances tell you how you have to spend it. If you take the time to do the math, you’ll discover how much control you have over your finances.