Discretionary income is a term commonly mentioned in conjunction with budgeting and student loans. Essentially, it’s the amount of money you can spend or save after you take care of all necessary expenses and income taxes. Discretionary income usually changes on an annual basis based on contributing factors that are both in and out of your control. So regardless of whether you’re getting together your annual budget or applying for a student loan, learning about discretionary income is important. If you have questions, speak with a financial advisor in your area.
What Is Discretionary Income, and How Does It Differ From Disposable Income?
Discretionary income is the amount of a taxpayer’s earnings that remains after subtracting income taxes and other mandatory costs, like rent, mortgage payments, food, transportation or insurance. For many people, the distinction between essentials and nonessentials is largely subjective. But although some may think that internet or their smartphone is a necessity, discretionary income calculations exclude these expenses.
Discretionary income is often confused with disposable income. To be exact, disposable income is how much money you have left after paying only income taxes. In other words, your disposable income is what you can spend on both necessities and nonnecessities. As a result of their differences, disposable income will always be higher than discretionary income.
How Discretionary Income Impacts Student Loans
It’s easy to see how disposable and discretionary income hold value in the context of a budget. When it comes to federal student aid and student loans, though, discretionary income means something slightly different. According to the U.S. Department of Education, “discretionary income is the difference between your annual income and 150% of the poverty guideline for your family size and state of residence.”
This type of discretionary income is used to determine the federal student loan repayment plans that are available to a borrower. With multiple repayment plans offered, the goal is to both reduce the number of student loan defaults and make payments more affordable for all borrowers. Some of these are called income-driven repayment (IDR) plans.
The aforementioned poverty guidelines are used to determine financial eligibility for various federally funded programs, including higher education financial assistance. Each year, the federal government releases a poverty guideline for every state and Washington, D.C. But since the cost of living is much higher in Alaska and Hawaii, these states receive unique poverty guidelines.
To calculate the poverty guideline, the government combines census data and the annual consumer price index (CPI) adjusted for inflation. The resulting number sets a minimum amount of income a family would need to take care of their bare necessities, like food and housing. Note that the poverty guideline is not intended to illustrate cost of living, but rather the income level of those officially in poverty.
How to Calculate Discretionary Income
To determine your discretionary income, you will need the following information:
- Your adjusted gross income (AGI) as reported on your taxes
- Your reported family size
- The poverty guideline for your state of residence
Based on this data, you can calculate your discretionary income by taking your adjusted gross income and subtracting 150% of your state of residence’s poverty guideline for your family’s size from it. You can find your adjusted gross income on line 27 of your most recent Form 1040.
For example, let’s say you make $40,000 a year. If you live in New York and are single, 150% of your poverty guideline is $18,735, meaning your discretionary income is $21,265. From here, you can generally expect to pay 10% to 20% of your discretionary income towards your student loans. That means monthly payments could range anywhere from $177 to $355.
Remember, your discretionary income will change annually, so don’t be alarmed if your payments shift. However, like your income and family size, poverty guidelines will also change. Therefore, it’s imperative to update your annual income to avoid placement in a standard repayment plan, which will likely increase your monthly payments.
If you need assistance when it comes to higher education costs, understanding how different terms play a role is crucial to your financial health. Being able to calculate discretionary income will help you predict your monthly payments so potential increases won’t come as a surprise. It will also help you ensure there are no errors when calculating your payment plan. If you have more questions, consider working with a local financial advisor.
Financial Planning Tips
- Remember, if you don’t receive the funding you need to supplement your higher education costs, you have other options. Knowing what’s available will help you select the most suitable financing option for your financial situation.
- If you want more help with this decision or anything else in relation to your financial health, you may want to consider working with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with top financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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