Disposable income is the amount of money that an individual or household has to spend or save after income taxes have been deducted.
Sometimes referred to as disposable personal income (or DPI) or disposable earnings, disposable income is closely monitored by government economists because it is a key indicator of the overall health of the economy.
Disposable income is also the foundation of your personal budget, as it is the starting point for how you decide to spend your money.
Understanding what disposable income is (and how it differs from discretionary income) is key to creating and living comfortably within your budget.
Read on to learn how to quickly calculate your disposable income, and then use this number to work towards your financial goals.
Why Disposable Income Is Important
Disposable income is usually defined as the amount of money you keep after federal, state, and local taxes and other mandatory deductions are subtracted from gross earnings.
Mandatory deductions include Social Security, state income tax, federal income tax, and state disability insurance.
It’s important to keep in mind, however, that disposable income is not the same as your net pay.
Voluntary deductions, such as health benefit deductions, 401(k) contributions, deductions for other employer-sponsored benefits, as well as any assignments of support (such as child support) are excluded from the calculation. These costs are considered part of your disposable earnings.
Disposable income is an important number not just for consumers, but also the nation as a whole.
The average disposable income of the country is used by analysts to measure consumer spending, payment ability, probable future savings, and the overall health of a nation’s economy.
International economists use national measures of disposable income to compare economies of different countries.
On an individual level, your disposable income is also a key economic indicator because this is the actual amount of money you have to spend or save.
For example, if your salary is $60,000, you don’t actually have $60,000 to spend over the course of the year.
If you live in Connecticut, for example, you would pay $6,187.50 in federal income tax, $2,100 in state tax, $3,720 in social security tax, and $870 for medicare. Your disposable income could land at $47,317. This is what you would have to spend on everything else in your life, such as housing, transportation, food, health insurance and other necessities.
Of course, that doesn’t mean you should spend all of your disposable income. Another thing to consider is disposable vs. discretionary income. This will tell you actually how much money you have to play with.
Disposable Income vs. Discretionary Income
Although they’re often confused with one another, disposable income is completely different from discretionary income.
While disposable income is your income minus only taxes, discretionary income takes into account the costs of both taxes and other essential expenses. Essential expenses include rent or mortgage payments, utilities, groceries, insurance, clothing, and more.
Discretionary income is what you can have leftover after the essentials are subtracted. This is what you can spend on nonessential or discretionary items.
Some costs that fall under the discretionary category are dining out, vacations, recreation, and luxury items, like jewelry. Although internet service and your cell phone may seem like necessities, these expenses are considered discretionary expenses.
As you might expect, discretionary income is always less than disposable income. When you subtract discretionary income from disposable income, the amount you come up is how much you can put towards savings.
Calculating Disposable Income
Disposable earnings refers to the amount of earnings left over after mandatory federal, state and local deductions. But disposable income is not necessarily the same as your take-home pay.
Deductions from your paycheck may include additional items such as health insurance, retirement plan contributions, and health savings accounts. These deductions are voluntary, not mandatory.
To calculate your disposable earnings, you can simply subtract federal, state and local taxes, Medicare, and Social Security from your gross earnings. The resulting amount is your disposable income.
You may want to keep in mind, however, that taxes deducted from your paycheck 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 calculate your disposable income.
This requires subtracting your quarterly tax payments and any additional taxes you will owe from your overall income. You can then determine your monthly after-tax income.
Setting aside money to pay taxes can also help you budget with your disposable income.
Disposable Income Budgeting
Calculating your disposable income is a key first step in preparing a budget. You need to know how much you have to spend in order to plan your monthly spending and saving.
A personal budget puts you in control of your disposable income and helps you make financial decisions. It forces you to take a closer look at how you’re spending your money.
Here are a few ideas that could be helpful when developing a budget based on disposable income.
Disposable income is what’s coming into your account every month. It’s a good idea to also determine what is going out each month.
To do this, you can gather up bank and credit card statements, as well as receipts, from the past three months or so, and then list all of your monthly spending (both essential and discretionary/nonessential).
To make this list more accurate, you may want to actually track your spending for a month. You can do this with a phone app, by carrying a small notebook and jotting down everything you buy, or by saving all of your receipts and logging it later.
This can be an eye-opening exercise. Many of us have no idea how much we’re spending on the little things, like morning coffees, and how much they can add up to at the end of the month.
Once you see your spending laid out in black and white, you may find some easy ways to cut back, such as getting rid of subscriptions and streaming services that you rarely use, brewing coffee at home, cooking more and getting less take-out, or getting rid of a pricy gym membership and working out at home.
Setting Goals And Spending Targets
Tracking income and spending can provide a great starting point for setting financial goals and spending targets.
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 how much you want to spend each month in general categories in order to have money left over to put towards your savings goals.
Since essential spending often can’t be adjusted, spending targets are typically for discretionary income.
One option for budgeting disposable income is the 50/30/20 plan. This suggests spending about 50% on necessities, 30% on discretionary items, and then putting aside 20% for savings and other long-term goals.
These percentages are general guidelines, however, and can be adjusted as needed based on individual circumstances.
For example, if you live in a competitive housing area, rent may take up a larger portion of your expenses, and you may have to bump up necessity spending to 55% or 60% and decrease fun money to 25% or 20% instead.
Or, if you are saving for something in the near term, like a car or a wedding, you may want to temporarily bump up the savings category, and pull back unnecessary spending for a few months.
Disposable income is a key concept in budgeting, as it refers to the income that’s leftover after you pay taxes.
Disposable income is distinctly different from discretionary income, which is what remains after you subtract other necessary costs from your disposable income. You might think of discretionary income as your “fun money.”
Knowing how much disposable income you have is the foundation for putting together a simple budget that allows for necessary expenses, having fun, while also saving for the future.
Want to get started budgeting, but not sure where to begin? Consider signing up for a SoFi Money® cash management account.
With SoFi Money, you can easily track your weekly spending right in your dashboard in the app.
SoFi Money also offers savings features like “vaults” that make it easy to put money aside for your short- and long-term financial goals.
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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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