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A huge part of attaining financial stability is understanding how to properly build a budget. Unfortunately, most people do not know how to build a budget or learn about it in school.
While it may seem very simple, several pitfalls can easily ruin your end goal of saving money. Miscalculating how much money you have is very easy if you aren’t aware of the proper steps you need to take or terminology.
Most people make a mistake when calculating disposable income. While you’ve probably heard the term before, you may not actually know what it means.
So, what is disposable income? And how can knowing your disposable income help you make better financial decisions?
This article will dig into these questions to help you build a more effective, smart budget.
Let’s get this party started.
What Is Disposable Income?
Your disposable income is simply your gross income after subtracting all of the taxes you have to pay.
For most people, this number will be the exact same number you see on your paycheck. If you have your employer withhold taxes for you already, you’re effectively receiving your disposable income directly.
That said, it gets a bit trickier for those who are self-employed or active in the gig economy. These individuals likely don’t have their taxes withheld, meaning they will have to calculate their discretionary income on their own.
>> More: Best Budgeting Apps
How Does Disposable Income Work?
Disposable income has to be calculated from gross wages. This can be done on an individual level or for a whole household depending on the number used.
Once the number is calculated, it is used for a wide variety of budgetary purposes.
The amount of disposable income is important on a larger scale because it is a big factor in determining the economy’s general health. Having low disposable income means individuals won’t be able to buy as many consumer goods. This is important to retail businesses, economists, the federal reserve, and politicians.
Additionally, having higher levels of disposable income is usually indicative of a solid economy in which workers are paid well.
Knowing these things can help inform policy and governmental action on a broad scale.
On a more individualistic level, knowing your disposable income will help you create a foundation to build a budget. This number will inform you how much you can afford to spend each month.
Your disposable income is also used to calculate other numbers, such as your discretionary income. These numbers further impact your budgeting, so you must know your disposable income.
How Do You Calculate Disposable Income? Formula and Example
Calculating disposable income is a simple task. All you need is your gross income and the state and federal taxes that will be withheld from that income.
Once you have these numbers, you simply subtract the taxes from your gross income to arrive at your disposable income.
The formula for this calculation is as follows:
Gross income – income taxes = disposable income
To better understand this, let’s take a look at an example.
Suppose you make $50,000 a year. This number represents your gross income.
Also, suppose that, on top of the federal income tax of 10%, your state income tax is 4%. This leaves us with a total income tax of 14%. 14% of $50,000 is $7,000.
To calculate your disposable income, we simply plug these numbers into the formula.
$50,000 – $7,000 = $43,000
So, in this example, your disposable income is $43,000.
How Disposable Income Impacts Your Budget
Disposable income impacts your budget in a few key ways.
For starters, your disposable income acts as the foundation of your budget. You need to know how much money you will have.
Many people mistake using their gross income rather than their disposable income when budgeting, leading to overspending or not saving enough money for retirement.
In addition, your disposable income is a key factor in your discretionary income, meaning you need to know this number to figure out how much you can spend on your desires and how much you will be able to save each month.
Is Disposable Income a Good Thing?
Disposable income is neither good nor bad. It is simply a term for the money you actually have to spend after your income is taxed.
If you have no disposable income, that is a definite red flag. This will only be the case if you are unemployed. For those currently unemployed, your priority is landing a job.
Are Discretionary Income and Disposable Income the Same Thing?
Discretionary and disposable income are not the same thing.
Disposable income is your gross income after subtracting taxes. Your discretionary income is your disposable income after subtracting all your basic necessities (think food, insurance, mortgage payments, etc.).
Discretionary income is calculated using your disposable income but is even more refined, showing you how much “free money” you have extra to spend each month.
>> More: Disposable vs. Discretionary Income
Bottom Line: What Is Disposable Income?
Disposable income is a simple but important concept. It is the amount of money you make after subtracting the taxes you have to pay on that money.
Knowing your disposable income is the first step in building a solid budget. Rather than your gross income, you should always use this number to determine how much you can afford to spend each month while still meeting your saving goals.