How to define and calculate your discretionary income

Managing your money wisely is an essential step for helping you meet your long-term goals. When you view money as a tool to help you accomplish specific tasks, the way you spend every dollar becomes more important. You need to know where your money goes, and a budget or spending plan can help you avoid spending more than you make each month. One important personal finance concept to understand when budgeting is discretionary income, which is the amount of money you have available to spend on non-essential items.

How to calculate discretionary income

Start by adding up your before-tax income from all sources, including side work like selling handcrafted items and unearned income like dividends from investments. Subtract payroll taxes and income taxes to get your take-home pay, which is sometimes referred to as disposable income. This is the money that you have control over choosing where it goes, but it’s likely that much of it is spent on your daily essentials and isn’t actually discretionary income.

To find your discretionary income, subtract all of your costs for personal necessities to maintain a basic standard of living. You can think of these as your monthly bills that you need to pay to have your basic needs met and stay on track with required debt payments. The typical costs that fall into this category are:

• Housing costs, which include your monthly rent or mortgage payment, property taxes, homeowners or renters insurance, and basic utility bills.
• Transportation costs, which could include car payments, gas, auto maintenance, and public transportation costs.
• Medical insurance and out-of-pocket medical costs.
• Food costs, which includes basic groceries but not extravagant or unnecessary meals out.
• Child care, elder care, child support, and alimony payments.
• Debt payments, including student loans, credit cards, and personal loans.

The importance of discretionary income in your financial decisions

Discretionary income is the money that you can spend at your discretion on whatever items you want, and you need to keep the amount in mind to make sure you’re only buying what you can afford. You’ll probably spend discretionary income in two major ways. First, you’ll make monthly commitments for non-essential costs, like cable or satellite TV, a fancy smart phone with data plan, a gym membership, or contributions to a savings account or retirement plan. Second, you’ll spend it on one-time purchases, like going to a concert, eating out at a fancy restaurant, going on a vacation, traveling to a friend’s wedding, buying gifts for others, or getting fun non-essential items for yourself.

If you find that you don’t have as much discretionary income as you would like, you have the tough job of either increasing your gross income or reducing your ongoing costs for personal necessities. A job with better pay or additional part-time work could help you increase your income, but it’s often easier to start by reducing your ongoing costs. One way to cut monthly costs is to reduce your debt payments by refinancing student loans, getting a lower interest rate, or changing your repayment schedule. You could also reduce your housing costs by moving to a less expensive apartment or getting a roommate. These strategies can help you avoid spending more money than you have.

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