Understanding Discretionary Income

Discretionary income is the money left over for spending, saving, or investing after covering essential expenses like taxes, housing, food, and clothing. These necessary costs, often called non-discretionary expenses, must be paid before determining your discretionary funds.

This income is typically used for nonessential purchases, such as luxury goods, vacations, and entertainment. Since discretionary spending declines during financial hardships like job loss or pay cuts, businesses that rely on selling nonessential products often experience the most significant impact during economic downturns and recessions.

The Role of Discretionary Spending in the Economy

Discretionary spending plays a crucial role in a thriving economy, as people only spend on nonessential items like travel, entertainment, and electronics when they have extra funds available.

While non-discretionary expenses—such as housing, taxes, debt payments, and groceries—are necessities, discretionary expenses go beyond basic needs and are typically associated with lifestyle choices. These expenses are not essential for daily living or business operations but enhance quality of life.

Individuals and businesses cover discretionary expenses using discretionary income, which is the money left after covering essential costs. During prosperous times, people tend to spend more on nonessential goods and services, such as vacations, dining out, gym memberships, and high-end electronics, fueling economic growth.

Calculating Discretionary Income

Discretionary income is a portion of your disposable income—the money remaining after taxes. To determine it, subtract essential expenses such as rent or mortgage, utilities, loan payments, car expenses, and groceries from your disposable income. The amount left after covering these necessities is your discretionary income, which can be used for saving, investing, or nonessential spending.

Understanding Disposable Income

Disposable income is the money left for spending or saving after deducting federal, state, and local taxes, as well as other mandatory charges.

Economists consider disposable personal income a vital measure of economic health. Also referred to as net income, it covers both essential expenses—such as housing and groceries—and discretionary spending on leisure, entertainment, and luxury items.

This income plays a vital role in the economy, influencing consumer spending, business earnings, and savings. It directly impacts demand for goods and services, production levels, and overall economic growth.

Economists use disposable income as a foundation for various financial indicators, including discretionary income, personal savings rates, marginal propensity to consume (MPC), and marginal propensity to save (MPS).

How to Calculate Disposable Income

Disposable income is typically calculated using the following formula:

Disposable Income = Total Income - Taxes - Mandatory Deductions

Total income includes all earnings, such as wages, salaries, and business income. In some cases, adjustments may be made, such as deducting returned sales for a sole proprietor.

Taxes are deducted because they are non-negotiable expenses. While individuals can adjust spending on discretionary items or necessities, tax obligations must be met, making them a fixed deduction from total income.

Discretionary Income vs. Disposable Income

While often used interchangeably, discretionary income and disposable income are distinct financial terms.

• Disposable income is the amount left after deducting taxes from gross income. It covers both essential and nonessential expenses and represents the net income available for spending, saving, or investing.
• Discretionary income is a subset of disposable income—what remains after covering necessities like rent, food, utilities, transportation, and insurance.

For example, if Elise earns $4,000 per month after taxes and has $2,000 in essential expenses, she has $2,000 in discretionary income. If her income drops to $3,000 per month, she can still cover her necessities, but her discretionary income shrinks to $1,000. This highlights how discretionary income is the first to decline during pay cuts or financial setbacks.

Conclusion

Understanding the difference between discretionary and disposable income is essential for managing personal finances and making informed financial decisions. While disposable income represents the money available after taxes, discretionary income is what remains after covering essential expenses. This distinction plays a crucial role in budgeting, investing, and ensuring financial stability, especially during uncertain economic times.

One smart way to make the most of your discretionary income is by investing it in opportunities that offer steady, reliable returns. Compound Real Estate Bonds (CREB) provides a high-yield option, offering 8.5% APY with no fees and anytime withdrawals. Whether you’re looking to grow your wealth, build an emergency fund, or generate passive income, CREB allows you to put your discretionary income to work effectively. Instead of letting extra funds sit idle, consider investing in a stable, asset-backed option like CREB to maximize your financial potential.