What is the difference between disposable income and discretionary income?
Disposable income is the amount of net income a household or individual has available to invest, save, or spend after income taxes. It's calculated by subtracting income taxes from income. For example, suppose a household has an income of $250,000 and it pays a 35% tax rate. The disposable income of the household is $162,500 ($250,000 - ($250,000*0.35)). Thus, the household has $162,500 to spend on necessities, luxuries, savings and investments.
On the other hand, discretionary income is the amount of income that a household or individual has to invest, save or spend after taxes and necessities are paid. Discretionary income is similar to disposable income because it's derived from it; however, there is one key difference. Disposable income does not take necessities into account. Necessities a household or individual may have are rent, clothing, food, bill payments, goods and services, and other typical expenses.
For example, suppose an individual has an income of $100,000 and pays a tax rate of 24%. The individual has transportation, rent, insurance, food and clothing expenses totaling $35,000 a year. His disposable income is $41,000 ($100,000 - ($100,000*0.24) - $35,000) for the year.
Disposable income is higher than discretionary income within the same household because expenses of necessary items are not removed from the disposable income. Both measures can be used to project the amount of consumer spending. However, either measure must also take into account the willingness of people to make purchases.
The terms disposable and discretionary income are sometimes used interchangeably, but there is a big difference in terminology to people that work in the financial, banking, or economic worlds.
Very simply, disposable income is money you have after taking out/paying your taxes. Discretionary income is money that is left over after paying your taxes and other living expenses (rent, mortgage, food, heat, electric, clothing etc). Discretionary income is based and derived on your disposable income.
Disposable income is basically after-tax income. That means your gross income, less the amount paid for federal and state income taxes, FICA taxes and local taxes. So if you earn $100,000 per year, and you pay $10,000 in federal income tax, $5,000 in state income tax, and $7,500 in FICA tax, your total taxes are $22,500. That will leave you with a disposable income of $77,500.
Discretionary income also subtracts out your taxes. But it also subtracts necessary living expenses, such as shelter, food, and clothing. So if your disposable income was $77,500, and you paid $20,000 for housing, $10,000 for food, and $2,500 for clothing, your discretionary income would be $45,000. That's the amount of money that you would have available for savings, investments, and luxury spending. The word "discretionary" applies since this is the income that you have greater control over. That is, it isn't committed to mandatory expenses.
When asked separately about the “disposable income” and “discretionary income,” most people probably answer without any hesitation. However, when you put them together, people do pause. Those two terms are almost identical in many people’s eyes—that’s the money to spend. However, there is a subtle difference between the two.
Discretionary income is one step further from the disposable income on the spending scale. It’s analogous to the terms of AGI and taxable income on the 1040 tax form. You first get the number of AGI on the front of 1040, then the taxable income on the second page of 1040. Simply put, disposable income is the first number after you subtract the tax withholding from your salary. In essence, the disposable income is your take-home pay. After you further subtract the fixed expenses (food, shelter, clothing, insurance, utility, etc.), the remaining income becomes your discretionary income for your wants and wishes.
Knowing that, you may want to set aside a certain dollar amount or a percentage to another checking/savings account automatically whenever you get paid. In doing so, you always pay yourself first and avoid any future disaster of living from pay-check to pay-check. Happy learning!
Disposable income and discretionary income can be thought of as the same thing. Both can be variable and fluctuate month to month.
Discretionary income is the money left over after your fixed expenses (i.e., mortgage, taxes, other payments) are paid. This the money you use for the necessities (i.e., groceries, personal care, medical) and they fluctuate.
Think of disposable income as your fun money. After all your bills are paid and your needs are met, this is the money you can use to put aside for savings or blow on a fancy trip.