Discretionary income is the portion of an individual’s income that remains for spending, investing, or saving after taxes and personal necessities—such as food, shelter, and clothing—are covered.
Discretionary income includes money spent on luxury items, vacations, and nonessential goods and services. This type of income is often the first to diminish during job losses or salary reductions, making businesses that offer discretionary goods more susceptible during economic downturns.
Key Takeaways
- Discretionary income is the money left after paying for taxes and essential goods and services like housing and food.
- It is often used for nonessential items such as vacations and luxury goods.
- Discretionary income differs from disposable income, which is the net income used for all expenses, both essential and nonessential.
- Economists use discretionary income to gauge economic health.
The Importance of Understanding Discretionary Income
Discretionary spending plays a crucial role in maintaining a healthy economy. People are likely to spend on travel, movies, and consumer electronics only if they have the means to do so.
Some individuals turn to credit cards for purchasing discretionary goods, but accumulating personal debt isn’t equivalent to having discretionary income.
Discretionary Income vs. Disposable Income
Discretionary income and disposable income are often used interchangeably, but they represent distinct financial concepts. Discretionary income stems from disposable income, which is your gross income minus taxes.
Simply put, disposable income is your take-home pay meant to cover both essential and nonessential expenses. When essential costs like rent, transport, food, utilities, and insurance are deducted from your disposable income, what remains is your discretionary income.
For example, if you earn $4,000 per month after taxes and have $2,000 in essential expenses, your monthly discretionary income is $2,000. If your income drops to $3,000 per month, you will have $1,000 left in discretionary income after meeting essential costs.
Discretionary Income and Economic Health
Discretionary income serves as a vital indicator of economic health. Alongside disposable income, it helps economists derive various economic ratios, such as the Marginal Propensity to Consume (MPC) and the Marginal Propensity to Save (MPS).
In 2005, during an economic bubble, the U.S. personal savings rate went negative for four consecutive months. Consumers spent all their discretionary income and more, utilizing credit to make additional discretionary purchases. Contrast this with 2020 during the COVID-19 pandemic—personal savings rates soared to record highs of over 30% for several months.
Overall, discretionary income levels tend to fluctuate in line with economic cycles. Higher economic output generally leads to increased discretionary income. However, if inflation impacts the cost of essential goods, discretionary income may fall, assuming wages and taxes remain constant.
Calculating Discretionary Income
Discretionary income is a subset of disposable income. Start with your disposable income and subtract essential expenses like rent, mortgage, utilities, loans, car payments, and food. The remaining amount for saving, spending, or investing is your discretionary income.
What is Considered a Good Level of Discretionary Income?
Although subjective and dependent on lifestyle, many experts advocate that 10-30% of your take-home (after-tax) pay should be discretionary income. The 50-20-30 rule suggests allocating 50% of your net income to living expenses, 20% to savings or investments, and 30% to discretionary spending.
Discretionary Income for Student Loans
For federal student loans or repayment plans, the U.S. government calculates eligibility based on discretionary income. Discretionary income, in this context, is defined as your annual gross after-tax income minus 150% of the federal poverty line (variable by state and family size). This calculation considers fluctuations in income levels.
Related Terms: Disposable Income, Marginal Propensity to Consume, Marginal Propensity to Save, Economic Ratios, Personal Savings Rate.
References
- Federal Reserve of St. Louis. “U.S. Personal Savings Rate”.
- Discover Financial. “The Beginner’s Guide to Budgeting with the 50-20-30 Rule”.
- Federal Student Aid. “If Your Federal Student Loan Payments are High Compared to Your Income, You May Want to Repay Your Loans Under an Income-driven Repayment Plan”.
