What Is Discretionary Income?
Let me tell you directly: discretionary income is the money you have left for spending, investing, or saving after you've paid your taxes and covered essential expenses like food, housing, and clothing.
This is what you use for luxury items, vacations, and nonessential goods and services. It often decreases when you face job losses or pay cuts, which means businesses selling these discretionary goods typically struggle 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
You should know that discretionary spending plays a key part in a healthy economy. People only spend on things like travel, movies, and consumer electronics if they have the extra funds.
Non-discretionary expenses are the mandatory ones, such as housing, taxes, debt, and groceries. Discretionary expenses are the additional costs, usually wants rather than needs, tied more to your lifestyle choices than daily necessities.
These discretionary expenses come from the money left after covering necessities like housing, food, and taxes. In a strong economy, you and others often use this extra money for luxury items, vacations, restaurants, entertainment, and other nonessential services.
Comparing Discretionary and Disposable Income: Key Differences
I need to make this clear: discretionary income and disposable income are different, even if people sometimes mix them up.
Discretionary income comes from disposable income, which is your gross income minus taxes.
Disposable income is your take-home pay, used for both essential and nonessential expenses. It's what's left after taxes, the net income you can spend, save, or invest.
In contrast, discretionary income is what's left from disposable income after paying for rent or mortgage, transportation, food, utilities, insurance, and other essential costs.
For most of us, discretionary income is the first to go when there's a pay cut. Take Elise, for example: she makes $4,000 per month after taxes with $2,000 in essential costs, leaving $2,000 in discretionary income. If her pay drops to $3,000, she can still cover essentials but only has $1,000 left for discretionary spending.
How Discretionary Income Impacts the Economy
Discretionary income is a crucial marker of economic health. Economists use it, along with disposable income, to figure out ratios like the marginal propensity to consume (MPC), marginal propensity to save (MPS), and consumer leverage ratios.
Back in 2005, during a debt-fueled bubble, the U.S. personal savings rate went negative for four months in a row. After paying necessities from disposable income, the average consumer spent all their discretionary income and more, using credit cards and debt for extra purchases beyond what they could afford.
In 2020, amid the COVID-19 pandemic and lockdowns, the U.S. personal savings rate hit all-time highs over 30% for several months. By late 2021 into 2022, it settled around 7%, closer to the long-term average, and has since fallen to 3.4% as of June 2024.
Overall discretionary income levels in an economy change over time, usually following business cycle activity. When economic output is strong, measured by GDP or similar, discretionary income tends to be high too. If inflation hits the price of necessities, discretionary income drops, assuming wages and taxes stay about the same.
Frequently Asked Questions
How do you calculate discretionary income? It's a subset of disposable income, which is all income after taxes. From disposable income, subtract necessities and obligations like rent or mortgage, utilities, loans, car payments, and food. What's left is your discretionary income for saving, spending, or investing.
What is a good level of discretionary income? This depends on your lifestyle, but many experts say 10-30% of your take-home pay should be discretionary. The 50-20-30 rule suggests 50% for living expenses, 20% for savings or investments, and 30% for discretionary spending.
How is discretionary income considered for student loans? For federal student loans or repayment plans, the government calculates eligibility based on discretionary income, defined as your annual gross after-tax income minus 100% to 225% of the federal poverty line (depending on your state, family size, and plan), accounting for any income changes.
The Bottom Line
To wrap this up, discretionary income is the funds you have after taxes and essential necessities like housing and food, often going toward nonessential spending on vacations and luxuries. It's a key indicator of economic health, showing consumer spending power across economic cycles.
Remember, disposable and discretionary income aren't the same: disposable is net after taxes for all expenses, while discretionary is what's left after essentials. Understanding this helps you manage your finances and align spending with your goals.
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