What Is Discretionary Income?
Discretionary income is the amount of an individual's income that is left for spending, investing, or saving after paying taxes and paying for personal necessities, such as food, shelter, and clothing.
Discretionary income includes money spent on luxury items, vacations, and nonessential goods and services. Because discretionary income is the first to shrink amid a job loss or pay reduction, businesses that sell discretionary goods tend to suffer the most during economic downturns and recessions.
Key Takeaways
- Discretionary income is money left over after a person pays their taxes and essential goods and services like housing and food.
- Nonessential items like vacations and luxury goods are usually paid for with funds from discretionary income.
- Disposable income and discretionary income are two different things.
- Disposable income is the net income of a person's take-home pay and is used to pay for all expenses (both essential and nonessentials).
- Discretionary income is used by economists to measure economic health.
Understanding Discretionary Income
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.
Some people use credit cards to purchase discretionary goods, but increasing personal debt is not the same as having a discretionary income.
Discretionary Income vs. Disposable Income
Discretionary income and disposable income are terms often used interchangeably, but they refer to different types of income.
Discretionary income is derived from disposable income, which equals gross income minus taxes.
Disposable income, in other words, is a person's take-home pay 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.
Discretionary income is what is leftover from disposable income after the 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. An example is if a person makes $4,000 per month after taxes and has $2,000 in essential costs, they have $2,000 in monthly discretionary income.
If their paycheck gets cut to $3,000 per month, they can still meet their essential costs but only has $1,000 leftover in discretionary income.
Discretionary Income and 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), 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 reached all-time highs in the U.S. of more than 30% for several months. From the end of 2021 into 2022, the rate has moderated to around 7%, more in line with the long-term average.
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, etc.. 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 goes 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 150% of the federal poverty line (which will depend on your state and family size) and takes into account any subsequent rise or fall in your income.
