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What Is Discretionary Income?
Discretionary income is money left for spending, investing, or saving after paying taxes and essential expenses like food, housing, and clothing.
Discretionary income covers spending on luxury items, vacations, and nonessential goods and services. It often shrinks after job losses or pay cuts, so businesses selling discretionary goods usually suffer during economic downturns.
Key Takeaways
- Discretionary income is the amount left after paying taxes and essential expenses, used for nonessential spending like vacations and luxury goods.
- Disposable income, different from discretionary income, is the net pay remaining after taxes, covering both essential and nonessential expenses.
- Economic health is gauged by discretionary income levels, with higher levels indicating stronger economies and vice versa.
- When income decreases, discretionary income typically diminishes first, impacting spending on nonessential items.
- Economists use discretionary income alongside disposable income to calculate important economic indicators like the marginal propensity to consume.
The Role of Discretionary Income in Economic Health
Discretionary spending is an important part of a healthy economy. People only spend money on things like travel, movies, and consumer electronics if they have the funds to do so.
Non-discretionary expenses are mandatory, like housing, taxes, debt, and groceries. Discretionary expenses are additional costs, usually wants rather than needs. They relate more to lifestyle choices than day-to-day operations.
Discretionary expenses are paid with money left over after covering necessities like housing, food, and taxes. When the economy is strong, people often spend their extra money on luxury items, vacations, restaurants, entertainment, and other nonessential services.
Comparing Discretionary and Disposable Income: Key Differences
Discretionary income and disposable income are different, even though people often use them interchangeably.
Important
Discretionary income is derived from disposable income, which equals gross income minus taxes.
Disposable income is a person’s take-home pay, which is used to meet both essential and nonessential expenses. This income is what is left over after taxes and it is the amount of net income available to spend, save, or invest.
By contrast, discretionary income is what is leftover from disposable income after an income-earner pays for rent/mortgage, transportation, food, utilities, insurance, and other essential costs out of their disposable income.
For most consumers, discretionary income gets depleted first when a pay cut happens. Let’s say, for example, Elise makes $4,000 per month after taxes and has $2,000 in essential costs, leaving her $2,000 in monthly discretionary income.
If Elise’s paycheck gets cut to $3,000 per month, she will still be able to meet her essential costs but she will have only $1,000 left over in discretionary income.
How Discretionary Income Impacts the Economy
Discretionary income is an important marker of economic health. Economists use it, along with disposable income, to derive other important economic ratios, such as the marginal propensity to consume (MPC), the marginal propensity to save (MPS), and consumer leverage ratios.
In 2005, in the midst of a debt-fueled economic bubble, the U.S. personal savings rate went negative for four consecutive months. After paying for necessary expenses out of disposable income, the average consumer spent all of their discretionary income and then some, using credit cards and other debt instruments to make additional discretionary purchases beyond what they could afford. In 2020, during the COVID-19 pandemic and the widespread lockdowns that resulted, the personal savings rate in the U.S. reached all-time highs of more than 30% for several months. From the end of 2021 into 2022, the rate moderated to around 7%, more in line with the long-term average, and has since dropped to 3.4% as of June 2024.
Aggregate discretionary income levels for an economy fluctuate over time, typically in line with business cycle activity. When economic output is strong, as measured by the gross domestic product (GDP) or another gross measure, discretionary income levels tend to be high as well. If inflation occurs in the price of life’s necessities, then discretionary income falls, assuming that wages and taxes remain relatively constant.
How Is Discretionary Income Calculated?
Discretionary income is a subset of disposable income, or part of all the income left over after you pay taxes. From disposable income, deduct all necessities and obligations like rent or mortgage, utilities, loans, car payments, and food. Once you’ve paid all of those items, whatever is left to save, spend, or invest is your discretionary income.
What Is Considered a Good Level of Discretionary Income?
This is somewhat a matter of lifestyle; however, many experts agree that around 10-30% of your take-home (after-tax) pay should consist of discretionary income. The so-called 50-20-30 rule suggests that 50% of your net income should go towards living expenses, 20% to savings or investments, and 30% to discretionary spending.
How Is Discretionary Income Looked at for Student Loans?
If you are looking at federal student loans or student loan repayment plans, the U.S. government will calculate your eligibility based on discretionary income. However, the government defines discretionary income as your annual gross after-tax income less than 100% to 225% of the federal poverty line (which will depend on your state and family size and the repayment plan you choose) and takes into account any subsequent rise or fall in your income.
The Bottom Line
Discretionary income represents the funds available after paying taxes and essential necessities such as housing and food, and it is often used for nonessential spending on vacations and luxury items. It serves as a significant indicator of economic health, providing insights into consumer spending power during various economic cycles.
While often confused, disposable and discretionary income are distinct: disposable income is the net income after taxes and covers all expenses, whereas discretionary income is what’s left from disposable income after covering essential costs. Understanding this distinction empowers individuals to manage their finances better, aligning spending with personal financial goals.
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