Once you have deducted taxes and the cost of daily necessities, you can spend the money left over as you see fit.
- Disposable income is your income that is left over after you pay taxes and make a living.
- Disposable income can be determined by tracking how you spend money on a personal cash flow statement.
- You can maximize your discretionary income by contributing to retirement accounts or investing it.
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When payday comes, it's tempting to think of that paycheck as money you can burn off. However, a significant portion of this money is already earmarked for rent, bills, and basic needs – not to mention taxes. When these parts are subtracted from your paycheck, you are left with only your discretionary income.
Here's everything you need to know about discretionary income and its role in planning your budget.
What is discretionary income?
Discretionary income is the income you are left with after taxes, and the cost of your basic needs – food, clothing, housing – are taken into account. Anything left over is considered discretionary income for additional expenses.
Disposable income vs. disposable income
Although discretionary income and disposable income are sometimes used interchangeably, there is a big difference between the two and how they are used.
Disposable income takes into account both taxes and living expenses.
Disposable income is your income that is left over directly after taxes.
It is more useful to think of discretionary income as a percentage of your budget.
It can be distilled down to a single number.
Disposable income is used to determine how much you should save and how much you can spend.
It is used by economists and government agencies as a measure to determine how the economy is doing.
How discretionary income is calculated?
As mentioned earlier, discretionary income is simply your income minus all taxes and non-discretionary expenses.
A good way to get an accurate view of your discretionary income is to work with a CFP® or other financial professional to create a personal income and expense statement – also known as a personal income statement. This is an important financial report that shows all income earned (or expected to be earned) within a given time period, minus recurring monthly expenses.
Note: Crucial expenses that don't go away, such as z. B. Your rent or electric bill, are considered "non-discretionary expenses".
Examples of income listed on this statement include your salary, interest, dividends, pensions, or business income received. Examples of recurring monthly expenses would be mortgages, taxes, internet, or insurance. Savings contributions would also fall under the spending category and include contributions to any type of savings account or retirement account.
Once you have all your information recorded in a personal income statement, you can calculate your so-called discretionary net cash flow. This represents available cash flow after all expenses, savings, and taxes have been paid. Here's the formula:
Income – savings – expenses – taxes = net free cash flow
Calculating your discretionary net cash flow is key to understanding how much money you have after you have met all of your debt obligations. From there, you can make decisions about what to spend and what to save and invest to maximize your discretionary income.
Note: The income statement would also capture variable and fixed expenses. Variable expenses would be vacation or entertainment expenses. Any one-time cash expenses would not be included in your personal income statement – these would instead be included in the cash flow statement, which is a separate financial document.
Not only does discretionary income vary from person to person, but it can also change over time. For example, the after-tax income you earn from a summer job in high school could be entirely discretionary, since you most likely rely on parents to cover bills and other expenses. But if you're older, perhaps graduated from college with an established career, your income and debt obligations would be quite different. Therefore, it is always important to regularly check what your income is and what you spend.
Another good rule of thumb is to look back at the past year of your spending and determine where your money is going. You can track your expenses for a personal cash flow statement. "Looking back is the best way to figure this out and then start budgeting into the future," says Todd Scorzafava, CFP® at Eagle Rock Wealth Management.
How is discretionary income calculated for student loans?
There are many different repayment plans for student loans. However, if you're looking for options tied to your discretionary income, you have several options:
- The Pay As You Earn (PAYE) repayment plan defines discretionary income as the difference between gross income, which excludes taxes, and 150% of the poverty guideline for your family size and state of residence. If you can qualify for this repayment plan, the monthly payment cannot exceed 10% of your discretionary income.
- The Revised Pay As You Earn (REPAYE) With the repayment plan, you also pay 10% of your discretionary income, which is determined using the PAYE formula.
- The Income-Based Repayment (IBR) plan requires you to pay 10% of your discretionary income if you borrow on or after 1. Have taken out a loan in July 2014. If you took out a loan before this date, pay 15% of your discretionary income. In this plan, discretionary income is defined using the same formula as the PAYE plan.
- The Income Contingent Repayment (ICR) plan uses a similar formula to determine discretionary income, except you only subtract 100% of the poverty guideline from your gross income. The payment amount under this repayment plan is the lesser amount required under a 12-year repayment plan adjusted based on your annual income – or 20% of the borrower's monthly discretionary income.
How much of my income should be discretionary?
A well-known guideline for dividing your income between necessities, savings and discretionary spending is the 50-20-30 rule. This means that you spend 50% of your income on necessities, 20% on savings, and 30% on everything else. Budgeting, however, depends on the person and their lifestyle and goals.
Quick tip: it is recommended that you keep your housing costs below 30% of your income.
When budgeting with discretionary income, Scorzafava reminds people to use a certain portion of that income for emergencies, whether it's for medical expenses or a car repair. "If there's no plan to cover these different categories in the cash flow and budget, people could fall into some pitfalls," he says.
There are also ways to increase the percentage of your discretionary income by paying less for everything else. For one, you can contribute to a retirement account such as a 401 (k) or an IRA, which lowers your taxes. Although it may seem obvious, even waiting for sales or finding coupons can free up money for discretionary income.
Investing also becomes a key component to growing, or at least maintaining, your discretionary income over time. Scorzafava says if you don't invest, "you will have less disposable income in the future because inflation will catch up with your assets."
While it's important to think carefully about how you spend your money, it's also important to remember that you can spend that income however you want, "making some of the decisions to go to a ballgame or a play or an opera or something," Scorzafava said. "There must be some joy, if you will, with the journey of a lifetime."