What Is Discretionary Income?
CS
Summary:
Discretionary income is money left over after you pay taxes and necessary expenses. Necessary expenses include mortgage payments, rent, utilities, and more. Discretionary income is used on nonessential items and determines how much your monthly student loan payments will cost.
It’s finally payday. You’ve received your paycheck, and now it’s time to pay the bills. Taxes have already been deducted, so there’s no need to worry about that. But you do have to pay rent and utilities, buy food and medicine, and so on. Afterward, you have some money left. This amount is your discretionary income.
Discretionary income is what money you have left after you’ve paid for necessary expenses and taxes. One very important aspect of discretionary income is how it affects government assistance programs such as student loan payments. For example, the cost of your monthly payments is partially based on your discretionary income.
So how much will your student loan payment be? And what else can you use your discretionary income on? This article will teach you how to calculate discretionary income, what it is, and what you can use it on.
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What is discretionary income?
Discretionary income is the money you have left over from your paycheck after you pay your basic living costs, also known as essential expenses. These expenses include rent, credit card debt, utilities, food, medicine, and more.
What is discretionary income used for?
What you spend your discretionary income on depends on your lifestyle and goals. But many people use their discretionary income for entertainment, travel, or saving for retirement.
How to use your discretionary income
Here are a few more ideas for what you can use discretionary income on:
- Add some into your savings or checking account
- Invest it! Turn your money into more money
- Entertainment or eating out
- Expenses for your hobbies
Your discretionary income is not just for spending. It’s also used to calculate how much your monthly student loan payment will be. The government uses your discretionary income to help determine the cost of your monthly student loan payment. Federal poverty guidelines also help them determine your student loan amount.
If you’re struggling to pay back federal student loans, look into an income-driven repayment plan. Discretionary income is a major part of income-driven repayment plans.
What is an income-driven repayment plan?
An income-driven repayment plan sets your monthly student loan payments at an affordable cost. The amount is based on your discretionary income, family size, and where you live.
Types of income-driven repayment plans
How to calculate discretionary income
You can calculate your discretionary income on an annual or monthly basis. However, the exact procedure for doing so, and the value that results, can vary.
Calculating discretionary income in general
Here are the steps to calculate your discretionary income:
- Determine your annual income. This is how much you earn in a year, whether you receive an annual salary or get paid hourly.
- Subtract taxes from your annual income. This new number is your adjusted gross income.
- After subtracting taxes, calculate the cost of your necessary expenses. This could be your monthly mortgage payments, groceries, medicine, and more. Subtract the total of these expenses from your adjusted gross income.
The total amount you have at the end of this is your discretionary income.
To calculate discretionary income with an income-driven repayment plan, you need to follow a somewhat different procedure. How you do the calculation depends on which plan you’ve chosen.
Calculating with REPAYE, PAYE, and IBR plans
Your discretionary income is the difference between:
- Your annual gross income and
- 150% of the poverty guideline.
Your student loan payments will always be 10% of your discretionary income.
Calculating with an ICR plan
If you have an ICR plan, your discretionary income is the difference between:
- Your annual gross income and
- 100% of the federal poverty guideline.
Your monthly payment will be either 20% of your discretionary income or the amount you would pay with a Standard Repayment Plan.
Pro tip: The U.S. Department of Health and Human Services (HHS) determines federal poverty guidelines and keeps them current. To see where your state of residence and family size put your income on the scale, check out the current guidelines.
Example of a Pay As You Earn plan
Hank lives by himself in Illinois. His annual income is $40,000 and he has $45,000 in student loan debt. He is using a PAYE plan to pay off his student loan.
His discretionary income is the difference between his annual income and 150% of the poverty guideline. The poverty guideline is $13,590. 150% of this is $20,385. Hank subtracts $20,385 from $40,000 and gets $19,615. This is his discretionary income.
His student loan repayment amount will be 10% of $19,615. This means his student loan payments will be around $1,962 a year, or about $164 each month.
Example of an Income-Contingent Repayment plan
Gail lives alone in Montana with an annual income of $40,000. She has $45,000 in student loan debt and has an ICR plan to pay it off.
To determine her discretionary income, she subtracts the poverty guideline from her annual income. Her poverty guideline amount is $13,590. The difference between that and her annual income is $26,410. This is her annual discretionary income.
To determine how much her student loan payments will be, she will take 20% of her discretionary income. This equals $5,282. This means she will pay about $440 a month toward her student loan debt.
Student loan refinancing: an alternative to IBR plans
Student loan refinancing is an alternative to income-based repayment plans that can sometimes be a good fit for borrowers with substantial incomes, reliable employment, and good credit scores. When done right, a student loan refinance can lower your interest (and monthly payments) and also simplify your finances by combining multiple loans into one. However, this may not always be the best choice because you could lose federal protections that are not available with student refinancing loans.
If you do decide to refinance your student loans with a private loan, make sure to shop around several lenders to find the best deal possible.
FAQ
How much of your income should be discretionary?
Obviously, there are no hard rules here. However, a good guideline for many people is to spend 50% of your income on necessities, 20% on savings, and 30% on whatever you want. In this case, 30% of your income is discretionary income. Of course, a lot depends on your priorities, responsibilities, and lifestyle, but it’s usually smart to keep your discretionary income between 20% and 30% of your total income.
Discretionary spending is not an entitlement. For sake of simplicity, we’ve assumed your discretionary spending cannot exceed your discretionary income. So, if you spend 30% of your income on whatever you want, at least 30% of your income must be discretionary. In fact, though, credit makes it possible to spend more than 100% of your income. This is possible, but it’s a bad idea. If your financial situation is such that you have to spend 70% of your income on necessities, for instance, you should reduce your discretionary spending to 10% so that you can still save (or invest) 20%. Don’t let yourself feel “entitled” to spend 30% of your income, or even 20%, on things other than savings and necessities. Treating discretionary spending you can’t afford as a “right” you must exercise could lead you to financial ruin.
Note: Both discretionary spending and savings (or investing) come out of your discretionary income. Financial prudence requires giving discretionary saving and investing priority over discretionary spending.
What’s the difference between discretionary income and disposable income?
Disposable income is money you have left over after you pay income taxes. Discretionary income is the remaining money you have after paying income taxes and necessary expenses.
Some lower-income families do not have enough disposable income to cover what they spend. In the 9th edition of their Economics textbook, Arizona State University professors William Boyes and Michael Melvin call this to readers’ attention:
Notice that at relatively low levels of disposable income, consumption exceeds disposable income. How can consumption be greater than disposable income? When a household spends more than it earns in income, the household must finance the spending above income by borrowing or using savings. This is called dissaving.”
If you find yourself in the same situation as some lower-income families, you may be able to work your way out of it. Even if you already follow a strict budget, there may be more you can do. If you have any excess time and energy, for example, you can turn that into added income with a side job.
What does discretionary income pay for?
Discretionary income can pay for any luxury or nonessential item. Such items can include gifts, vacations, hobbies, and more.
Key takeaways
- Discretionary income is the amount of money you have remaining after you’ve paid taxes and covered essential expenses.
- Necessary expenses include rent, mortgage payments, utilities, and food.
- Discretionary income determines how much your student loan payments will be if you’re on an income-driven repayment plan.
- You can use your discretionary income to pay for any nonessential expenses.
Learn which IDR plan fits your needs
There is much more to learn about when it comes to income-driven repayment plans. We talked a little about them here, but if you think they’d be helpful to you, check out this article. It provides a more in-depth look at each plan, and it could help you decide which one (if any) is best for you.
CS
Camilla has a background in journalism and business communications. She specializes in writing complex information in understandable ways. She has written on a variety of topics including money, science, personal finance, politics, and more. Her work has been published in the HuffPost, KSL.com, Deseret News, and more.
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