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BANKINGFORTUNERECOMMENDSBANKINGWHAT IS DISPOSABLE INCOME AND HOW SHOULD YOU USE IT?

What does it mean to have disposable income and how should you use it?

October 31, 2022, 1:27 PM UTC
Photo illustration of a woman wearing a white coat and carrying multiple shopping bags around her forearms.
Disposable income is not the same as discretionary income.
Photo illustration by Fortune; Original photo by Getty Images

When creating a budget and setting financial goals for yourself, it’s important to know how much money you’re working with. Spoiler: It’s not the number on your biweekly pay stub—it’s your disposable income. 

Your disposable income is the amount that you have available to spend once Uncle Sam has gotten his cut. Let’s start with the basics. 

What is disposable income? 

Disposable income, also known as disposable personal income (DPI) is the amount of net income you have available after you’ve paid local, state, and federal taxes. This figure is also a key economic indicator used to measure the health of the economy. When consumers have more disposable income, that means they have more money available to pour back into the economy. 

As of 2021, the average American has $56,088 in disposable income each year, according to the most recent data from the Fed. 

“Disposable income is used to pay for living expenses and the essentials of life—rent, mortgage, transportation, food, and insurance,” says Trevor Yochum, certified financial planner, CIMA®, managing partner, and investment advisor at Incompass Financial Partners. 

Your disposable income will be different from everyone else’s, and will likely change throughout the course of your life as your financial circumstances change. Here’s a closer look at the average disposable income per capita over the last century, or so. 

How do you calculate your disposable income? 

You can figure out how much disposable income you earn each month by calculating the difference between the income you earn and the taxes you owe. The taxes you owe will depend on what your salary is, your state, and your filing status. For the 2023 tax year, tax rates range from 10% to 37%

Say you earn $2,500 per month, and your employer deducts $250 per paycheck for taxes; your monthly disposable income would amount to $2,000. 

Heads up: If you’re self-employed, you won’t have an employer to do the heavy lifting of withholding taxes for you. You’ll need to crunch the numbers yourself to make sure you have enough stowed away to cover what you owe when tax season arrives. 

What is disposable income used for? 

First off, your disposable income should not be confused with your discretionary income. That’s the money you have left over after all of your necessary expenses have been covered. You have the freedom to use these funds however you like. On the contrary, your disposable income should be used to cover your cost of living and non-negotiable expenses. 

“Disposable income is used for living expenses and other necessities [such as your] mortgage or rent, transportation, health insurance, and food. What is left over after the essentials have been taken care of is discretionary income,” says Yochum. “Discretionary income can either be saved or used on entertainment [such as] travel, going out to eat, concerts, or sporting events.” 

To calculate your discretionary income, you would take your disposable income and subtract all of the payments needed to cover your necessities. Certain budgeting strategies like the 50/20/30 method can make breaking this down a bit simpler by categorizing your spending into your needs (50%), wants (20%), savings and debt payments (30%). 

“If someone were to have a loss in income, discretionary expenses should be an area individuals review to determine what expenses can be eliminated from their budgets,” says Yochum. 

The takeaway 

Creating a strong financial foundation for yourself starts with knowing the basics. By taking a close look at how much income you’re bringing in and how to best allocate those funds, you can ensure that you’ll be able to weather any financial setback that comes your way and hit all of your major money goals.

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