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If you are interested in the world of personal finance, you probably already know that building a budget is crucial to achieving long-term financial freedom.
Budgeting isn’t just as simple as throwing out arbitrary numbers to stick to. Creating a proper budget takes time, deep personal reflection, and understanding where your money is spent.
One of the most important numbers you need to calculate is your discretionary income.
Knowing your discretionary income will give you insight into the amount of money you can spend on your wants, desires, and frivolities. It will also let you know how much you can reasonably expect to save.
What is discretionary income, though? How do we calculate it? And why is it so important for budgeting?
This article will give you all the information you need to understand discretionary income.
To start, let’s define discretionary income.
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What Is Discretionary Income?
Discretionary income is a key factor in budgeting. It is the number that tells you how much you can afford to spend on non-necessities.
Discretionary income is the amount of money you make after subtracting your disposable income and the fundamental expenses you need to survive. This includes things like your rent, food bill, utilities, and your car payments.
The amount you are left with is your discretionary income. This money can be used for whatever you want. However, those longing for financial freedom tend to invest, save, or pay down debt with their discretionary income.
How Does Discretionary Income Work?
For most people looking to understand personal finance, discretionary income is primarily viewed as a means of saving or investing.
That said, discretionary income doesn’t have to be used for saving. It can be spent on leisure and entertainment, on enjoyment-based purchases, to pay off debt, or whatever else you may want to use the money for.
Outside of personal budgeting, discretionary income is also used to calculate debt payments. This is particularly prevalent if you are carrying any student loans.
If you choose to opt for an income-based repayment plan, student loan collectors will typically base your payments on your discretionary income.
This ensures you are charged an amount you can afford to spend without seriously harming you financially.
Discretionary income can also be a useful metric for institutions looking to understand the economic landscape.
Consumer goods are bought with discretionary income, so understanding how much discretionary income the average individual has is a good predictor for the broader economy.
How Do You Calculate Discretionary Income? Formula and Example
If you are trying to build a budget or understand your finances, you’ll want to know how to properly calculate your discretionary income. Luckily, the process is simple.
You’ll need to know three things to calculate: your gross income, your state, and federal income taxes, and your essential expenses.
Once you know these, simply plug them into the following formula:
Gross income – income taxes – essential expenses = discretionary income
To better understand this, let’s look at an example.
Suppose you make $100,000 a year in gross income. Your state taxes are 4%, and your federal taxes are 10%. In addition, your essential expenses are $40,000. The calculation would look like this:
$100,000 – $14,000 – $40,000 = $46,000
So, in this example, your discretionary income would be $46,000 a year. This number represents the money you can save or spend without running into issues with your bills or going hungry.
How Discretionary Income is Used (Two Simple Ways)
Discretionary income is used primarily in two simple contexts. Let’s look at what they are and why they matter.
Student Loan Repayments
The first scenario where you’ll typically see discretionary income used is in student loan repayments.
Because students cannot always make payments fresh out of school, student loan collectors will often offer income-based repayment plans. These plans will almost always use the discretionary income to calculate the payments.
This is because, by pulling from discretionary income, the collector can be sure that the debtor can make the payment.
This also ensures that the payments don’t cause serious financial problems for the debtor, as they are only forced to pay an amount that won’t interfere with them buying food or paying rent.
The second-place discretionary income is typically used is when consumers build a personal budget.
Discretionary income is money that you can spend in flexible ways. You can dedicate it all to savings, spend it all, or anything in-between. The decision is yours.
Because of this, understanding how much of your income is discretionary is foundational to setting a weekly budget and sticking to it.
Is Having Discretionary Income a Good Thing?
Having discretionary income is absolutely a good thing. The more discretionary income you have, the more you can afford to save, pay off debts, and make nonessential purchases.
All else equal, more discretionary income is always better than less.
What Are the Differences Between Discretionary Income and Disposable Income?
While discretionary and disposable income are often used as interchangeable, the two are different.
Disposable income is gross income with taxes subtracted.
Discretionary income builds on this by subtracting out essential purchases from disposable income. As such, your discretionary income gives you more insight into how much money you have free at the end of each month and year.
>> More: Disposable vs. Discretionary Income
Bottom Line: What is Discretionary Income?
Discretionary income is simply the amount of money you have after taking your income taxes and essential expenses out of your gross income.
This number gives you a clear idea of how much money you have to play with after your needs are met.
You can use this information to make a smart budget, setting aside some of your discretionary income to save or pay off debts each month.
Doing this is a huge step forward in better managing your personal finances.