What Is Discretionary Income?
Discretionary income is the amount of money that you have left for spending, investing, or saving after you've paid your taxes and paid for personal necessities, which include food, housing, and clothing—so-called non-discretionary expenses.
Discretionary income includes money spent on luxury items, vacations, and nonessential goods and services. Because discretionary income is the first to shrink after a job loss or pay reduction, businesses that sell discretionary goods tend to suffer the most during economic downturns and recessions.
Key Takeaways
- Discretionary income is money left over after a person pays their taxes and for essential goods and services like housing and food.
- Nonessential items like vacations and luxury goods are usually paid for with funds from discretionary income.
- Disposable income and discretionary income are not the same thing.
- Disposable income is the net income of a person's take-home pay and is used to pay for all expenses (both essential and nonessential).
- Discretionary income is used by economists to measure economic health.
Understanding Discretionary Income
Discretionary spending is an important part of a healthy economy. People only spend money on things like travel, movies, and consumer electronics if they have the funds to do so.
While non-discretionary expenses are considered mandatory—housing, taxes, debt, and groceries—discretionary expenses are any costs incurred above and beyond what is deemed necessary. These are generally considered wants, while non-discretionary expenses are usually referred to as needs. As such, discretionary expenses rarely have anything to do with a business or household's day-to-day operations and, instead, have to do with lifestyle and choice.
Businesses and individuals pay for discretionary expenses withdiscretionary income—the amount of money left over after paying for housing, food, taxes, and other necessities. When times are good, people have more money to spend, and they normally do so on things they don't need, such as luxury items and other services—vacations, restaurants, entertainment, electronics, gym memberships, etc.
Discretionary Income vs. Disposable Income
Discretionary income and disposable income are terms often used interchangeably, but they refer to different types of income.
Discretionary income is derived from disposable income, which equals gross income minus taxes.
Disposable income is a person's take-home pay, which is used to meet both essential and nonessential expenses. This income is what is left over after taxes and it is the amount of net income available to spend, save, or invest.
By contrast, discretionary income is what is leftover from disposable income after an income-earner pays for rent/mortgage, transportation, food, utilities, insurance, and other essential costs out of their disposable income.
For most consumers, discretionary income gets depleted first when a pay cut happens. Let's say, for example, Elise makes $4,000 per month after taxes and has $2,000 in essential costs, leaving her $2,000 in monthly discretionary income.
If Elise's paycheck gets cut to $3,000 per month, she will still be able to meet her essential costs but she will have only $1,000 left over in discretionary income.
Discretionary Income and the Economy
Discretionary income is an important marker of economic health. Economists use it, along with disposable income, to derive other important economic ratios, such as the marginal propensity to consume (MPC), the marginal propensity to save (MPS), and consumer leverage ratios.
In 2005, in the midst of a debt-fueled economic bubble, the U.S. personal savings rate went negative for four consecutive months. After paying for necessary expenses out of disposable income, the average consumer spent all of their discretionary income and then some, using credit cards and other debt instruments to make additional discretionary purchases beyond what they could afford. In 2020, during the COVID-19 pandemic and the widespread lockdowns that resulted, the personal savings rate in the U.S. reached all-time highs of more than 30% for several months. From the end of 2021 into 2022, the rate moderated to around 7%, more in line with the long-term average, and has since dropped to 3.4% as of June 2024.
Aggregate discretionary income levels for an economy fluctuate over time, typically in line with business cycle activity. When economic output is strong, as measured by the gross domestic product (GDP) or another gross measure, discretionary income levels tend to be high as well. If inflation occurs in the price of life's necessities, then discretionary income falls, assuming that wages and taxes remain relatively constant.
How Is Discretionary Income Calculated?
Discretionary income is a subset of disposable income, or part of all the income left over after you pay taxes. From disposable income, deduct all necessities and obligations like rent or mortgage, utilities, loans, car payments, and food. Once you've paid all of those items, whatever is left to save, spend, or invest is your discretionary income.
What Is Considered a Good Level of Discretionary Income?
This is somewhat a matter of lifestyle; however, many experts agree that around 10-30% of your take-home (after-tax) pay should consist of discretionary income. The so-called 50-20-30 rule suggests that 50% of your net income should go towards living expenses, 20% to savings or investments, and 30% to discretionary spending.
How Is Discretionary Income Looked at for Student Loans?
If you are looking at federal student loans or student loan repayment plans, the U.S. government will calculate your eligibility based on discretionary income. However, the government defines discretionary income as your annual gross after-tax income less than 100% to 225% of the federal poverty line (which will depend on your state and family size and the repayment plan you choose) and takes into account any subsequent rise or fall in your income.
The Bottom Line
Discretionary income is money left over after a person pays their taxes and pays for essential goods and services like housing and food. Nonessential items like vacations and luxury goods are usually paid for with funds from discretionary income. Discretionary income is used by economists to measure economic health.
Disposable income and discretionary income are two different things. Disposable income is the net income of a person's take-home pay and is used to cover all expenses (both essential and non-essential).
