You’ve likely heard terms such as net income, gross income, adjusted gross income, take-home pay, and disposable income. But do you really know what each term means, both in definition and how it relates to your financial health? And if you don’t, how can you move forward with a realistic budget in mind? To understand what disposable income is, it also is important to understand how it differs from discretionary income and how to budget effectively.
What Is Disposable Income?
The money you have left over from your salary after you’ve paid federal, state, and local taxes is your disposable personal income (DPI), also referred to as your net pay.
Disposable income also has economic significance. Not only is it one of the major determinants of consumer spending, but it is also one of the five determinants of demand, which represents how many goods and services are bought at various prices during a certain period of time. In short, how much disposable income someone has helps determine how much money they spend on goods and services.
What Isn’t Considered Disposable Income?
But don’t spend all your disposable income just yet. Disposable income is not to be confused with discretionary income, which takes it a step further. That is what is left of your disposable income after you’ve spent for necessities like rent, your mortgage payments, healthcare, transportation, and clothing.
Discretionary income can be spent on eating out, investing, travel, and any other non-essential items or expenditures. It’s your fun money to spend with limited guilt on things you don’t actually need, knowing that your other expenses are taken care of.
Budget Your Disposable Income
It’s important to budget your disposable income. While there are various different types of budgeting systems—the 50/30/20 rule, the envelope system, the 80/20 method, a traditional line-item budget, or even the “pay yourself first” method—it really comes down to personal circumstances and preferences when selecting which method to use. Be honest with yourself because there’s no point in having a budget if you aren’t going to stick to it or if it’s unrealistic for your current lifestyle or situation.
Some questions to consider before choosing a budget: Do you have student loans? Credit card debt? Do you like padding your savings, or would you rather invest your extra funds and only keep the bare minimum in liquid cash? Are you a spender or a saver? How often do you eat out? Do you like to travel frequently or are you more of a homebody? Do you have expensive tastes or do you like to be frugal in your purchases?
Many experts say your necessities—rent or mortgage payment, food, taxes—should account for only 50 percent of your budget, while discretionary spending should account for 30 percent or less. The remaining 20 percent should be used for other financial goals, such as paying off debt, saving, or investing.
Once you decide your financial priorities, then you are able to find the budget that works best for you. And when filling in your budget, don’t forget these often-overlooked budget busters, such as entertainment, gifts, or annual dues.
How to Cut Disposable or Discretionary Spending
If the numbers just aren’t adding up, it may be time to re-evaluate your spending habits and cut back where you can. Try a worksheet that helps prioritize what you really need and what you might be able to do without to cut back on discretionary spending.
Some helpful tips to trim your budget might include combining errand trips to save money on gas, stopping or limiting eating out, paying off debts as soon as possible to save money on interest, buying groceries in bulk from a club store, or reducing cable bills by selecting a cheaper package.
Some discretionary spending items you could probably cut without issue include that never-used gym membership, a biweekly manicure/pedicure or other spa treatment, magazine or live streaming subscriptions, professional societies or club dues, and even holiday gifts.