What Is Discretionary Income?
Discretionary Income Explained in Less Than 2 Minutes
Discretionary income refers to the amount of income left over after accounting for taxes and essential day-to-day expenses. It's distinct from disposable income, which is simply the amount of income left over after taxes are taken out.
While discretionary income is beneficial for the individual because it helps clarify where you spend your money, it's also used in certain official financial calculations. For example, it's used by the Federal Student Aid Office to determine the amount of money you can afford to pay toward your student loans with an income-driven repayment (IDR) plan.
Learn exactly what discretionary income is, how you can use it, and how it differs from disposable income.
Definition and Examples of Discretionary Income
Discretionary income is the income you have left over to spend, save, or invest after you pay taxes and other essentials such as rent or mortgage, utilities, food, and credit card bills.
Discretionary income is less than both total income and disposable income because it's income you can use at your discretion. Since everyone has to pay for certain essentials, such as food and housing, you have to subtract those costs to determine your individual discretionary income.
The more fixed financial obligations you take on, the lower your discretionary income will be. For example, a large housing payment in addition to other essential costs will reduce the income you have left over.
How Does Discretionary Income Work?
For most people, discretionary income matters because it's the amount of money left in your budget that you can allocate toward spending and saving. You'll distribute that leftover income among expenses such as retirement savings, debt payments, dining out, entertainment, and anything else you want to do with your money.
In some cases, though, discretionary income has a more specific definition. If you have federal student loans and choose an income-driven repayment plan, for example, discretionary income is used to determine how high your monthly loan payments will be. These plans require that you pay a percentage of your discretionary income, which varies depending on each plan.
How to Calculate Discretionary Income
For Individual and Family Expenses
You can calculate your discretionary income simply by subtracting the cost of your necessities from your take-home pay, and you can do so on a monthly or annual basis. This example shows how to calculate it annually:
- Determine your total income. For most people, this is their annual salary, as well as income from any part-time work. For example, if your job pays $48,000, that would be your annual income.
- Subtract for taxes. The specific amount you'll owe depends on your filing status, your state, and your deductions. For this example, let's say your annual payroll taxes are $8,000.
- Subtract for essential expenses. This would include your rent or mortgage, utilities, groceries, insurance premiums, and payments for other essentials. Let's assume these add up to $25,000 annually.
- What's left over is your discretionary income. In this case, your discretionary income would be $15,000. This would be the money left over to spend on everything else, such as saving for retirement, paying debt, entertainment, and dining out.
You can divide annual expenses by 12 to determine your monthly discretionary income, which would be beneficial if you keep a monthly budget.
For an Income-Driven Repayment Plan
For income-driven repayment plans, discretionary income isn't just calculated by subtracting your fixed costs from your total income. To make sure payments are fairly determined for each borrower, a standard formula is used to calculate discretionary income for student loan payments.
Your discretionary income is calculated in one of two ways:
- If you're on the Income-Based Repayment (IBR) Plan, the Pay As You Earn (PAYE) Repayment Plan, or loan rehabilitation, your discretionary income is determined by calculating the difference between your annual income and 150% of the federal poverty level based on where you live and your family size.
- If you're on the Income-Contingent Repayment (ICR) Plan, your discretionary income is calculated by determining the difference between your income and 100% of the federal poverty level based on your state and family size.
You can find the poverty guidelines used for this calculation on the website of the Department of Health and Human Services. Depending on the payment plan you choose, you will pay between 10% and 15% of your discretionary income—the amount calculated above that varies for each individual—each month.
In some cases, calculating your discretionary income will result in a payment of $0 per month for income-driven repayment plans. Months when you pay $0 are still counted toward determining eligibility for federal student loan forgiveness.
Discretionary Income vs. Disposable Income
Disposable income and discretionary income aren't the same, although they are commonly thought to be. Disposable income is higher than discretionary income because it's calculated only by subtracting taxes from your earnings rather than subtracting both taxes and the cost of necessities. For this reason, discretionary income can provide a more accurate picture of the money you have available.
The table below is a hypothetical example illustrating the difference between discretionary and disposable income if you earn $48,000 a year.
|Disposable Income||Discretionary Income|
- Discretionary income is the leftover income over after taxes and essential expenses are paid.
- Discretionary income, for purposes of income-driven student loan plans, is calculated by comparing your income with the federal poverty level.
- Disposable income is different from discretionary income because it does not factor in essential expenses, it’s simply your income minus taxes.