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. It usually changes on an annual basis based on contributing factors that are both in and out of your control. Regardless of whether you’re working on your annual budget or applying for a student loan, learning about discretionary income is important. If you have questions, consider speaking with a financial advisor.
What Is Discretionary Income?
Discretionary income is the amount of a taxpayer’s earnings that remains after subtracting income taxes and other mandatory costs. Those costs can include things 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 and Economic Indicators
Discretionary income serves as a critical indicator of economic health. It provides insight alongside disposable income, helping economists derive key metrics such as the marginal propensity to consume (MPC), marginal propensity to save (MPS) and consumer leverage ratios.
In 2005, during a period of debt-driven economic expansion, the U.S. personal savings rate turned negative for four consecutive months. After covering essential expenses, the average consumer not only exhausted their income, but also relied on credit cards and other debt sources to fund additional discretionary purchases.
Fast forward to 2020, the COVID-19 pandemic and related lockdowns pushed the personal savings rate in the U.S. to record highs of over 30% for several months. By late 2021 and into 2022, this rate normalized to around 7%, closer to historical averages. By June 2024, however, it dropped to 3.4%.
Aggregate discretionary income levels generally move in tandem with the business cycle. When economic output is strong, as measured by GDP or similar indicators, discretionary income tends to rise. Conversely, when inflation drives up the costs of essentials, it typically decreases. That is, of course, assuming wages and tax rates stay relatively steady.
How Discretionary Income Impacts Student Loans
It’s easy to see how income holds 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 income is used to determine the federal student loan repayment plans that are available to a borrower. With multiple repayment plans available, the goal is to both reduce student loan defaults and make payments more affordable. 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. Rather, it’s the income level of those officially in poverty.
How to Calculate Discretionary Income
To determine your discretionary income, you’ll 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.
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. This will likely increase your monthly payments.
Discretionary Income vs. Disposable Income
Though often used interchangeably, discretionary income and disposable income refer to distinct types of income.
As we discussed above, disposable income is your gross income minus taxes, representing your take-home pay. This is the income available for covering both essential expenses – like housing and food – and nonessential expenses. Essentially, it’s the net income you have available to spend, save or invest after taxes.
Discretionary income, on the other hand, is what’s left after you use your disposable income to cover essential expenses, such as rent or mortgage, transportation, food, utilities and insurance. This income represents what you have for nonessential spending, savings or investments.
For most people, this type of income is the first to be impacted by a pay cut. For example, if you earn $4,000 per month after taxes and spend $2,000 on essential costs, you have $2,000 in discretionary income. If your pay drops to $3,000 per month, you can still cover your essentials, but your discretionary income is reduced to $1,000.
Bottom Line
Being able to calculate discretionary income will help you predict your monthly payments and other expenses. This helps you ensure any potential increases won’t come as a surprise. It will also help you ensure there are no errors when calculating payment plans. If you have more questions, consider working with a 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 a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area. You can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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