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 37% tax rate. The disposable income of the household is $157,500 ($250,000 - ($250,000*0.37)). Thus, the household has $157,500 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 35%. The individual has transportation, rent, insurance, food and clothing expenses totaling $35,000 a year. His disposable income is $30,000 ($100,000 - ($100,000*0.35) - $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 Advisor Insight
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.
Peter J. Creedon
Crystal Brook Advisors
New York, NY