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When you were a kid, every dollar you made was probably spent on something fun and frivolous. Candy or toys or shiny new clothes were the only things worth purchasing, as your parents handled all the necessities like food and shelter.
Alas, getting older comes with bills and necessary expenses. There’s rent, groceries, gas, and all sorts of other payments that simply must be made if you want to survive and enjoy life.
Interestingly enough, not many of us learn to manage our finances or shift our perspective on dividing up our money. This leads to all sorts of financial problems down the road.
Understanding how to manage your finances can avoid these problems, and one of the simplest and most helpful places to start is learning the difference between discretionary and disposable income.
What is discretionary income? What is disposable income? How should you handle each?
This article will explore the differences between Disposable Income and Discretionary Income.
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Disposable Income vs. Discretionary Income: Overview
Most people confuse disposable and discretionary income. This is understandable, as the two do have some similarities.
Both disposable and discretionary incomes are incomes that have had some necessary deductions factored in. They both represent the amount of money you will end up receiving when considering unavoidable expenses.
The difference is the number of expenses that get factored in.
Both discretionary and disposable incomes provide you numbers that can help you build a budget properly. For this reason alone, it is worth gaining a deeper understanding of both concepts.
Understanding Disposable Income
As stated above, disposable income represents your income after a certain number of unavoidable expenses are factored in. In the case of disposable income, these expenses are just state and federal taxes.
This means that your disposable income represents how much money you have to spend on necessities, like rent and health insurance.
If you are working for an employer and already have your taxes withheld, your disposable income is likely the exact amount you receive from your paychecks.
This number is helpful in many respects but is particularly useful in big-picture planning. Using your disposable income to decide on big purchases such as houses or cars will ensure you don’t stretch yourself too thin or lock yourself into payment plans you can’t maintain.
Understanding Discretionary Income
Discretionary income is similar to disposable income in that it factors in the taxes you must pay on the money you earn. However, discretionary income goes a step beyond disposable income.
In addition to your taxes, discretionary income deducts the money you spend on necessities from your income. This means things like mortgage payments or the food you need to survive.
Discretionary income gives you an idea of how much money you can spend on frivolous things and still meet your basic financial obligations.
Discretionary income doesn’t need to be spent, though. It can and often should be saved or invested.
It is important to note that discretionary income only factors in actual needs. For instance, you need to eat, but that doesn’t mean every dollar spent on food should be subtracted when calculating your discretionary income.
If someone goes out to eat every night, they are likely spending far more on food than they need to. This means they are spending their discretionary income on food.
Knowing your discretionary income is a great way to build a budget and set yourself up for financial stability. You can use it to segment the money you have to spend, setting some aside each month for savings and debt and ensuring you don’t mindlessly overspend.
What Is the Difference Between Discretionary and Disposable Income?
As we’ve said above, both discretionary and disposable income are numbers that show you how much you earn after factoring in necessary deductions. The difference between the two is the number of costs factored in.
Disposable income is simply your income after taxes. It is a tool that shows you how much money goes to your bank account. This money can be spent on anything, including necessities.
Discretionary income factors in your basic needs in addition to the taxes you must pay on the money you earn. You find this number by taking your disposable income and subtracting your rent, base grocery bill, and other necessities.
The two are different in the numbers they will produce and how they should be used when budgeting.
Disposable income is better suited to help you make decisions on fixed expenses. Things like where you live and what car you drive should be considered in the context of how much disposable income you bring home.
By contrast, discretionary income is great for helping you plan out variable expenses. Since discretionary income already factors in most large purchases and expenses, it can help you save money day-to-day.
This isn’t always the case, as some variable expenses such as groceries might need to be subtracted to calculate your discretionary income, but it is a good place to start when trying to get a broad understanding of the two concepts and use them to build a budget.
>> More: Fixed vs. Variable Expenses
What Are Some Examples of Discretionary Income?
Several things factor into your discretionary income. Examples of expenses you should subtract from your disposable income to get your discretionary income include rent, car payments, utility bills, basic groceries, and health insurance. There are more, but these are some common discretionary income examples.
What Is a Good Discretionary Income?
As a rule of thumb, you should strive to have about 50 percent of your income as discretionary income. This is typically enough to have quite a bit of financial freedom while also setting aside money each month for savings or for paying down bills.
Bottom Line: Disposable Income vs. Discretionary Income
Both disposable and discretionary income are great tools for better understanding your financial situation.
Disposable income can give you insight into how much you can afford to spend on the necessities like your home and your car.
Discretionary income can help you fine-tune your budget to consistently better your financial standing and set yourself up for success in the future.
Calculating both your disposable and discretionary income is a great place to start if you are trying to form a budget.