By Laurel Nelson-Rowe | American Express Credit Intel Freelance Contributor
6 Min Read | August 13, 2020 in Money
Discretionary income is the spending money you have left over after paying for necessities like food, shelter, and clothing.
You’ll need to figure out your discretionary income if you want to make a financial management plan.
Knowing what affects your discretionary income – and how you can flex your needs – can help you stay financially fit now, and in the future.
I’ve never really liked budget management. But a recent job change – sorta planned – and a recent auto accident – very unplanned – forced me to rework my household budget. Not a recalibration or simple expense reset. A complete overhaul. In the process of realigning my needs, wants, and spending tradeoffs, I realized that an empowering and effective financial management plan requires you proactively understand the concept of discretionary income.
Why? Discretionary income will be the first part of your budget to shrink after a job loss, pay reduction, or, in my case, car troubles. The good news is that learning how to flex your discretionary income can help you make the best out of any scenario, be it now or in the future.
But what exactly is discretionary income, and how do you figure yours out?
Discretionary income is the amount of your income, or your household’s, leftover to spend, invest, or save after taxes and after spending on necessities. Generally speaking, necessities are food, shelter, and clothing.1 “Discretionary spending” is the term more often used in everyday conversations, but it’s derived from your discretionary income. Discretionary spending is a cost for something that is not essential to you personally or to your household,2 like little and big luxuries, vacations, and entertainment. Put simply, it’s the flipside of necessity/needs.
There’s a lot going on in there, so understanding what discretionary income means for you and your household might require your close scrutiny. For example, what you – or others in your household – deem as “necessities” can prompt debate and disagreement. But to get to the basics, necessities are needs and obligations that you must pay for at monthly or other regular intervals.
The terms “disposable income” and “discretionary income” often get used interchangeably, but they’re actually two very different things. Disposable income is the amount you have left to spend or save after paying taxes.3 Often called your “take-home pay,” disposable income is what you have in hand, in a paycheck, or directly deposited, after federal, state, and/or local/municipal taxes are subtracted.
Your disposable income can also be affected by benefits like retirement account contributions, health insurance, and others.4 Experts note that disposable income can reflect several sources, such as: salary, freelance work, retirement benefits, Social Security, dividends, rental income, and child support.5
Discretionary income, on the other hand, is the portion of your disposable income leftover after you pay for your necessities.
To figure out your discretionary income, a simple calculation might look like this: Discretionary Income = Disposable Income – Necessary Expenses.
Since your discretionary income depends on your needs – and necessities lists can be extensive – everybody’s calculation is different. For example, if you need a car, you’ll also need to pay for car insurance, registration, repair, and gas expenses. A house can mean mortgage, insurance, utilities, and upkeep. Rent can mean rent, rental insurance, and maybe even parking fees. Food ranges from everyday groceries to birthday and anniversary dinners out, and even gala events. Some list healthcare insurance under necessities, and many college grads include student loan repayment obligations.
As you can see, these “necessities” change a lot depending on your personal circumstances.
Discretionary income can be affected by changes in salary, jobs, and tax rates. A pay cut, whether at your current employer or a new job with a lower starting salary, would likely affect discretionary income, meaning you might have to refocus your budget on necessities.
Yet, as I learned, needs can be reexamined. For instance, we’ve put replacing the totaled car on pause. We’re walking more. We’re using ride hailing services and public transport. We could save at least $1,200-plus this year if we can maintain our single-car lifestyle. Beyond the car, we may refinance the mortgage again given recent attractive rates, and we’re shopping the healthcare exchanges. Reexamining what contributes to our discretionary income has helped us to think a bit more flexibly about our budget.
Global factors and federal policies can also impact individual and household economics. For many Americans, discretionary income was hit hard by the Great Recession – and some say its after-effects still linger.6 The economy was strong last year, which could indicate higher discretionary income. But if inflationary times return, discretionary income and spending may decline as prices on necessities increase. Since a combination of personal and external factors can affect your discretionary income, it’s important to be vigilant and maintain your budget as needed. With that in mind, I intend to make regular attention to discretionary income my new practice – instead of only when circumstances significantly change.
Some observers say discretionary income should be 30% of your take-home pay. If that’s unachievable, they suggest you reprioritize needs and wants.7
Another approach gaining visibility is the “50/20/30 budget rule.”8 With this approach, 50% of after-tax income is allocated to needs and obligations, 20% to savings and debts, and 30% to wants. Again, given your priorities and personal preferences in each category, you may have to make some choices as to what’s a need and what’s a want. Regardless, experts advise a minimum three months of after-tax income in an emergency fund beyond regular savings, investment, and retirement funds.
For me, changes in income and expenses triggered a budget exercise to reassess my disposable income, discretionary income, and discretionary spending. Understanding the concept of discretionary income helped something click in my mind: regular budget maintenance and monitoring keeps you financially fit so you can achieve the quality of life you seek, now and later. It’s kind of like eating right and exercising, and all of the health benefits and sense of wellbeing that they bring.
1 “Discretionary Income Defined,” Investopedia
2 “Discretionary Expense,” Investopedia
3 “Disposable Personal Income,” US Bureau of Economic Analysis
4 “What is discretionary income and what does it mean for my student loan?,” Policygenius.com
5 “What You Really Should Be Doing With Your Discretionary Income,” Listen Money Matters
6 “The Great Recession,” Federal Reserve History
7 “What Percent of Your Take-Home Pay Should Be Discretionary Income?,” thenest.com
8 “What is the 50/20/30 Budget Rule?,” Investopedia