Disposable income is a consumer finance term used to describe your income after the deduction of taxes. It is a significant indicator of personal wealth and one of the tools we use to measure the state of the economy for consumers.
There is a lot more to it than that, however. The better you understand the ins and outs of your disposable income, the better handle you will have on your financial situation.
What Is Disposable Income?
Once you take your income and subtract your taxes (federal, state, and local), your required paycheck deductions (Social Security, Medicare, unemployment insurance, back taxes, and court-ordered child support), and any other mandatory government payments (licenses, fees, and permits), what remains is your disposable income.
Voluntary automatic contributions from your paycheck for retirement savings or 401(K) plans are not part of disposable income. They are not mandatory payroll deductions.
Disposable income is money available for you to do the following with:
- Invest. Investing is a good use of your money as it helps you set the stage for your future financial health and wellbeing.
- Save. This includes saving for emergencies, setting and reaching financial goals, etc.
- Spend. The bulk of your income is likely to be spent on essentials and non-essential goods and services. It includes money you spend on housing, whether that is through a mortgage or rent.
- Give. Making charitable donations is an admirable way to use your money.
It includes the amount you can do all the above without having to draw or liquidate assets.
The basic formula to calculate disposable income is simple:
Gross income — taxes, required payroll deductions, and mandatory government fees = disposable income
However, disposable income includes all income received by an individual but not necessarily earned. Examples include unemployment compensations, social security benefits, food stamps, veteran benefits, and welfare payments. Disposable income includes all of these. Disposable income does not include realized or unrealized capital gains or losses from investments.
How Does it Work?
Disposable personal income is a crucial indicator of wealth for the national economy. So much so that the U.S. Bureau of Economic Analysis (BEA) releases information on the changes in disposable personal income from month to month.
Ultimately, your disposable income is the money you are supposed to live on from month to month. It is the amount of money upon which you base your budget for each month and annual spending.
You can use your disposable income to determine how much you can afford to spend on necessities. That includes rent or mortgage payments, rainy day savings, what you can invest, and what you have leftover for discretionary spending each month.
The U.S. Government uses disposable income numbers and other economic statistics to determine the health of the U.S. economy, especially as it relates to personal savings rates. For instance, during recessionary times, the personal savings rate dips into negative territory, indicating that Americans have to dip into their savings to cover essential living expenses.
Disposable vs. Discretionary
It’s important to understand that disposable income and discretionary income are not the same, although people often confuse them. Disposable income is the total amount of money you have to work with for the month.
Discretionary income includes money you use to pay for the essentials, which include things like:
- Housing
- Utilities
- Insurance
- Child care
- Transportation
- Food
- Educational loan repayments
- Credit card and loan payments
Discretionary income also includes income you have available for expenses that aren’t necessary for living, such as:
- Clothing and accessories
- Dining out
- Gourmet coffee runs
- Date night
- Luxury items, such as jewelry
- Cell phone services
- Game subscriptions
- Entertainment
- Subscription services and accounts
- Recreation
- Vacations
As you can see, discretionary funds, while derived from disposable income, are not the same. When working out payment plans and calculating available funds for these instances, some organizations use discretionary income. Others use disposable income to determine how much you can afford to pay each month.
Takeaway
There are critical differences between discretionary income and disposable income.
Understanding what disposable income is and how it is different from discretionary income can help you budget more effectively.
Calculating disposable income can help you determine how much money you can reasonably apply to certain expenses in your life before you commit to them.