What Is Discretionary Income And How Do You Calculate It?

Discretionary income is important to understand, whether you're using this number for budgeting purposes or paying back your student loans. In essence, it's the amount of money you have left over after accounting for the necessities. These can include housing, minimum debt payments and healthcare costs.

So, what exactly is discretionary income and how can you calculate it to help you reach your overall financial life goals?

Discretionary Income Definition

Discretionary income is defined as post-tax money you have after subtracting necessary spending, whether that’s your mortgage, utilities, transportation, or insurance expenses. In other words, clothing you buy “just because” and not because you need it for your child who outgrew theirs won’t count as necessary expenses.

While you can use it to help you create a budget, discretionary income is also used for student loan purposes.

The US Department of Education uses your discretionary income to calculate how much your monthly payments should be for income-driven or income-based repayment plans. The idea is to see how much you can reasonably afford to pay back your federal loans each month after taking into account your necessary spending. The US Department of Education has a guideline it uses to ensure it calculates discretionary income fairly for all.

Discretionary Expenses

Part of understanding the definition of discretionary income is knowing the types expenses that qualify:

• Vacations: While it’s nice to be able to rest and relax, spending money on holidays isn't exactly considered necessary to your daily life.
• Streaming services: While watching the latest series release is fun, this type of expense is considered discretionary.
• Entertainment and eating out: Yes, food is necessary, but dining out every day or getting fancy drinks at your local restaurant technically isn’t.
• Luxury items: This can include sports cars, wine, jewelry and designer handbags.
• Gifts: Of course you want to show family and friends you care, but unfortunately buying presents isn’t key to your survival.
• Supplies or memberships for hobbies: Going to your local yoga studio or buying paint for your new art project doesn’t count as necessary for your daily life.
• Personal care items: With the exception of shampoo, toothpaste and toothbrushes, other items such as massages and facials aren’t technically essential.

Discretionary Income Vs. Disposable Income

While disposable income and discretionary income may sound like they mean the same, they are different. Disposable income is the amount you have after taxes. It doesn't take into consideration any other expenses like necessities. Therefore, this number tends to be higher.

Discretionary income, on the other hand, is the amount you have after deducting taxes and necessities — it includes deductions and expenses like your housing, food, and transportation. 

Knowing your discretionary income and disposable income can help you stay on track with a budget. For one, your disposable income is the amount you have to spend on all your expenses, necessary or not. Go over this number and you’ll end up overspending and possibly getting into debt. For many, this number is where they start to create a budget, whether you’re using tactics such as the 50/30/20 method or zero-based budgeting.

Discretionary income, however, can serve as a guideline as to how much you can spend on the nice-to-have or fun items. You can use this number to track your spending to make sure you’re not overspending. Or, this amount can be used towards other financial goals as well, such as paying down debt faster.

How To Calculate Discretionary Income

To calculate discretionary income, take your income and subtract from it the taxes you pay and any essential expenses. Meaning, if you earn $60,000 per year but pay $7,000 in taxes and spend $35,000 per year on essentials, your discretionary income is $18,000 per year, or $1,500 per month.

$60,000 – ($7,000 + $35,000) = $18,000 in yearly discretionary income

If you need to calculate discretionary income for student loan purposes, the formula looks a little different. Instead of looking at your individual expenses, it's based on a standardized calculation from the U.S. Department of Education looking at your income and poverty guidelines for your household size and location.

Here’s how the formula works:

• Find the standardized calculation for income and poverty from the federal poverty guideline based on your state of residence and household size
• Multiply the number you find by 1.5
• Determine your adjusted gross income (AGI) - you should be able to find this number on your income tax return
• Subtract the number you calculated based on the federal poverty guidelines from your AGI

Keep in mind that certain types of federal student loan repayment plans, like the income-contingent repayment, use 100% of the federal poverty guideline amount instead of 150%. For the above formula in this instance, you won't need to multiply the applicable federal poverty guideline amount by 1.5.

If you’re unsure or need more guidance in calculating your discretionary income for student loan repayment plans, you can contact your loan servicer or the office of Federal Student Aid.

Discretionary Income Example

For a more detailed view as to how you would calculate discretionary income for your own personal finances, we’ll walk through an example:

We’ll say your income after taxes is $56,000 per year (or $4,666 per month), your discretionary income is $6,800 per year or around $566 per month. So you can spend up to $566 a month on items such as streaming services and yoga memberships knowing you have taken care of essential expenses like your rent.

$56,000 – ($4,100 x 12) = $6,800 per year

When it comes to calculating your discretionary income for student loan purposes, you would need to figure it out using the formula mentioned earlier. For the sale of this calculator, let’s assume. you’re single, live in the state of Florida and your AGI is $26,000 per year.

Here’s how you would calculate it:

• 2023 federal poverty line: $14,580
• Multiply by above amount by 1.5: $21,870
• Subtract above number from AGI: $26,000 - $21,870 = $4,130

Your discretionary income is $4,130. This amount will be what the Department of Education will use to calculate how much your student loan payments for certain income-based repayment plans. 

The Bottom Line: You Get To Decide How You Spend Your Discretionary Income

Your money is yours, and how you choose to spend it will be based on your goals and other circumstances such as your health and family needs. While it can feel hard to budget your income at times, what may give you hope is that your discretionary income is yours to spend on non-necessities. Remember, this amount is what you have after taking into account your tax obligations and necessary expenses. Meaning, you’ve taken care of your rent or mortgage, food costs, transportation and other expenses like debt and insurance premiums.

Life can be hard enough, and it can be even harder if you deprive yourself of some of the nicer things. It’s fine to splurge every once in a while on a nice dinner out, or buy a dress for your 40th birthday — assuming you have the financial means to do so. If you’re responsible with your money, there’s nothing wrong with enjoying it.

To make sure you’re on track with your spending and saving goals, consider using free tools like the Rocket Money℠ app. You can use it to easily track your income and spending so you can manage your expenses and discretionary income. Download the app today and see how much simpler it can be to enlist the help of technology instead of tracking income and expenses manually.