Individuals and businesses earn income—money for providing goods or services or by investing capital in vehicles like individual retirement accounts (IRAs). Other sources of income include pensions or Social Security. This income may be used to fund day-to-day expenditures and necessities or to spend on things people want rather than need.
Income can be divided into two different categories: Disposable and discretionary income. These are two different measures used to analyze the amount of consumer spending. Both are key economic indicators used to gauge the health of an economy. So how do they differ?
- Disposable income is the net income available to invest, save, or spend after income taxes.
- Disposable income is calculated by subtracting income taxes from income.
- Discretionary income is what a household or individual has to invest, save, or spend after taxes and necessities are paid.
- Both disposable and discretionary income are similar, except disposable income does not account for necessities.
Disposable income is one of the economic indicators used to analyze the state of the economy. It is the amount of net income a household or individual has available to invest, save, or spend after income taxes. Disposable income is 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—that is, $250,000 - ($250,000 x 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 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. But 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 discretionary income is $30,000. This is calculated as $100,000 - ($100,000 x 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.
Peter J. Creedon, CFP®, ChFC®, CLU®
Crystal Brook Advisors, New York, NY
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.