Most of us know we should have a household budget and plan how to use our disposable income—but that doesn’t mean we’re all doing it. A recent poll found that just 67% of families have a budget. That number was higher among the younger demographic, though, possibly because of the rise of budgeting and personal finance apps.
But it’s hard to budget without knowing what your disposable income is, or how it differs from discretionary income. All these terms can get confusing, but they don’t have to be. Ultimately, understanding how to calculate disposable income can help you budget towards your financial goals.
Defining Disposable Income?
The money you have after you pay taxes is considered your disposable income, also known as net income. It’s your income minus income taxes. People typically spend their disposable income on necessities, savings, and discretionary items.
The reason it’s important to know what disposable income is and what it isn’t is that you need to know how much money you actually have in order to budget appropriately.
For example, if your salary is $90,000, you don’t really have $90,000 to spend. After you pay federal, state, and local taxes, depending on where you live, you could end up with just $64,000 to $70,000 in disposable income/net pay.
Of course, that doesn’t mean you should spend all of your disposable income. Another thing to consider is disposable vs. discretionary income. Your net income after taxes is not the same as the income you have to spend on discretionary items.
What is Discretionary Income?
Discretionary income is the amount of disposable income you have left after you pay for necessities like housing, food, and healthcare. Think of it as the money you have discretion over—e.g. after your financial obligations, you can choose to save or to spend what’s left on things like travel or eating out or other non-essential items.
A household’s disposable income is typically higher than its discretionary income because necessary expenses have not yet been factored in. Think of your income as a big bucket. Take out taxes and that’s disposable income. Then take out necessities and financial obligations and what’s left is discretionary income.
Calculating Disposable Income
It can be a little difficult to calculate disposable income depending on how complicated one’s taxes are. Disposable income is calculated by subtracting income taxes from gross income.
For example, you could multiply your tax rate by your income and then subtract that amount to find your disposable income. Sometimes calculating a person’s tax bill can be a bit more complicated. Some may find they fall into multiple tax brackets and additional taxes including medicare, social security, and state taxes may need to be factored in.
However, for the most part, if your taxes are withheld from your paycheck, then you should know how much you net into your bank account post-taxes. Remember, though, taxes withheld from pay are an estimate.
If you have a history of getting a large refund or having a large amount of taxes due, it may be worth reviewing your withholdings through your employer. This could help you adjust the withholdings so it is closer to the actual expected tax that will be calculated when you file. You can then plan accordingly.
Even if you’re a contractor or freelancer, or if you made additional income from side gigs along with your salary, you can still plan ahead by subtracting from your overall income whatever you owe in quarterly taxes or any additional taxes. Setting aside money to pay taxes can also help you budget with your disposable income.
To calculate discretionary income, you take your disposable income and then subtract all your regular necessary expenses.
The government, though, has a standardized way to calculate discretionary income—which comes into play when determining income-driven student loan repayment plans.
The standardized process requires subtracting 100% or 150% of the federal poverty guidelines from your adjusted gross income to determine your official federal discretionary income.
Once you know your disposable and your discretionary income, you can start building a workable budget.
Managing Disposable Income
Calculating disposable income can be helpful to create an understanding of the money available to an individual. Understanding how much money is flowing in can be useful when managing a budget.
After all the money that’s owed to Uncle Sam isn’t available for spending. Setting a budget based on post-tax disposable income could prevent overspending money that is earmarked for other purposes. Uncle Sam, then it’s not yours in the first place.
Additional budgeting recommendations might include setting goals, getting into the details of your spending, and planning ahead. Here are a few ideas that could be helpful when developing a budget based on disposable income.
One way to get started is to create a tracker for existing spending habits. If it’s unclear where money is being spent, it can be more challenging to budget or plan ahead. Starting a tracker can provide a baseline of current habits so changes in behavior and spending are easier to see.
Tracking expenses could also spotlight the areas where overspending might be occurring. Then this information can be used to help inform new spending limits and budgeting goals. Effectively managing overall expenses could make it easier to spend on wants.
For example, if a family wanted to take a trip to Europe, they may be surprised to find out too much of their budget is being spent on money is going to coffee, eating out, or pricey boutique exercise classes. Identifying those areas and adjusting the budget accordingly, could help that family board a plane to France even sooner.
There are different ways to track spending. To track manually, one might start by gathering all their account information and going through the last month or last few months’ of expenses. Adding in any annual expenses that might not have occurred during that time period, like insurance payments.
Tracking spending for a few months, should reveal some patterns in where money is being spent—things like food, loan payments, entertainment.
Creating an income log could also be helpful if a person’s income fluctuates from month to month. This way there is visibility into how much money is coming in, as well as how much is going out.
Setting Goals or Spending Targets
Tracking income and spending can provide a starting point to set additional financial goals and spending targets. Will retirement be a main focus? Is saving for a wedding or a down payment on a home a priority?
Goals are things that a person aims for in the short- or long-term—like paying off student loans or buying a new car. Spending targets are broad targets for how much you want to spend each month in general categories.
Spending targets are typically for discretionary income since recurring necessary expenses can’t always be adjusted, and often include savings targets for longer-term goals.
A good rule of thumb to budget disposable v. discretionary income is the 50-30-20 rule. That means only budgeting post-tax income. And then, of that post-tax disposable income, spending about 50% on necessities, 30% on discretionary items like travel and fun, and then putting aside 20% for savings and other long-term goals.
While the 50/30/20 budgeting rule has been around for years, it was popularized in Elizabeth Warren’s book, All Your Worth: The Ultimate Lifetime Money Plan .
A general spending target like the 50/30/20 rule offers flexibility for any emergencies or costs might come up. These categories are guidelines that can be adjusted as needed based on individual circumstances.
For example, for someone living in a competitive housing rent may take up a larger portion of their expenses. If desired, they could increase their necessity spending to 55% or 60% of their budget and decrease their fun money to 25% or 20% instead.
Setting spending targets can also be impactful since studies have shown that writing down goals can increase a person’s chance of achieving them.
Evaluating and Adjusting
Another step is re-evaluating the budget and spending so adjustments can be made as needed. If any issues sticking to the budget creep up, explore what the root cause might be.
Is there any opportunity to make simple cuts like picking non-brand items at the grocery store or eliminating a daily coffee run.
Simply looking at the budget, tracking, and checking in on spending periodically could help cut extra expenses.
Shopping with credit cards can make it easier for consumers to spend money, which means people often spend more with a credit card than they would if they were using cash. In that case, some people may find it helpful to limit their credit card use by setting aside a certain amount of cash or using a prepaid debit card.
It can also be key to plan ahead and align personal goals with spending. For example, if a person’s main focus is on existing credit card debt, they’d build their debt repayment strategy into their monthly budget.
Consider planning ahead for expenses that can be expected at specific times—Tax Day is always on April 15, Christmas is always on Dec. 25.
Managing and budgeting disposable income is just one part of an overall financial plan. And it can be hard to get right.
Getting Financial Help
If achieving financial goals and sticking to a budget continue to be difficult, it might be worth seeking additional assistance.
That could come in the form of a cash management account like SoFi Money®. With SoFi Money you can keep track of your spending with your weekly dashboard in the app.
Also, every SoFi member has complimentary access to certified financial planners who could assist in creating personalized financial plans.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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