What is a Discretionary Income?
Discretionary income refers to the portion of gross income available after paying taxes, obligate payments like rent, and other essentials like food. It capacitates people to enjoy luxuries of life and has a positive influence in improving the quality of life.
The continuous inflow of such income makes people materially well-off, have enough savings, financial investments, and lead desired life. Moreover, as discretionary spending increases, it triggers money flow in the nation and subsequent economic growth.
Table of contents
- Discretionary income refers to the income left after deducting all taxes and necessary expenses.
- Since necessary expenses may differ for each individual, the discretionary expense is not the same for all people.
- The study and analysis of discretionary spending are useful for marketers and policymakers to frame better policies and design better products for consumers.
- The discretionary portion is used for savings, spending, and investments. During periods of low economic activity, policymakers incentivize individuals and businesses to direct their discretionary portion towards spending and investing activities.
Discretionary Income Explained
Discretionary income powering the earners with discretionary spending and expansionary monetary policyExpansionary Monetary PolicyThe central bank uses expansionary monetary policy to increase the supply of money while lowering the interest rate and increasing demand. This is done to boost a country's economy. stimulates economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.. Such circumstances manifest an increase in durable and nondurable consumption. Thus, businesses continue to reinvestReinvestReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio. more of their profits back into expanding their activities in anticipation of future demand. In essence, it contributes to increased spending, savings, and investments altogether, contributing to a healthy economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society..
Sufficient income for necessities and leisure expenses will develop a healthy society. Many people live below the poverty level, and their income doesn’t even meet the costs for a quality diet. For them being able to extract a discretionary portion will improve their nutritional status and contribute to overall development.
Knowing the pertinent facts related to discretionary spending is vital to governments and businesses. It gives policymakers information on identifying marginal and underserved communities deprived of resources accessible to others and helps plan policies that address such inequalities. The proposal for income-based repayment plans for student loans is an example.
The discretionary income data is also useful to marketers and companies. Knowing the discretionary income by demographic categories can help improve the targeting and segmentation of products offered by various industries. When combined with allied statistics regarding consumer spending, savings, and investments, the data could be a gold mine for companies to build better products for consumers.
How to Calculate Discretionary Income?
Often there is a disparity in what may be perceived as essential and non-essential expenses for living. Calculation of discretionary portions is often subject to a lot of debate. Generally, the formula is as follow:
Discretionary income = Gross Income – Taxes – Essential Expenses
Essential expenses normally include rent payments, utility bills like electricity and gas bills, grocery bills, and loan repayments. Furthermore, discretionary income calculators are also available online.
Mr. A lives in New York and works as a tax consultant in a private company earns an annual salary of $85,000. The year has just started, and he decided to be more financially disciplined this year and wanted to plan the budget. As part of the exercise, he calculated the discretionary income available.
First, he calculated the taxes he needed to pay under the federal and state tax codes. His tax liability in the current financial year will be $14,317. After allocating the amount for tax liabilities, the income amounts to $70,000, equal to the disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes.. The income net of taxes, also called disposable income, is what he has to allocate for essential and non-essential expenses. Next, he tabulated the expenses he incurs every month regularly, which are necessary, and converted it into an annual basis. Deducting these essential expenses from disposable income gives discretionary income, as shown below.
Using the formula given earlier,
Discretionary income = Gross Income – Taxes – Living Expenses
= $85,000 – $15,000- $51,600
This $18,400 is available to Mr. A every year for all leisure activities, savings, and investments after meeting all tax and necessary expenses.
Disposable vs Discretionary Income
The term disposable indicates what is available or obtainable, whereas discretionary indicates optional. Hence in an economic scenario, disposable income represents the part of gross income available to the earner after deducting the tax liabilities. From the disposable portion, the earner can use it for various purposes like meeting essential or non-essential needs. Separating the amount for essential expenses from the disposable part of the earning gives the discretionary part, and the earner uses it at his discretion.
In conclusion, it is derivable that the disposable part goes to settling necessities. When gauging life in terms of wants and needs, disposable income is what an entity would be spending on the basic needs impossible to avoid. These could be the rent, expenses on food, water, and gas bills, etc. At the same time, the discretionary part of the earning extracted from the disposable portion is not attributed to settling any obligations. The income available can be spent on the wants in your life, leisure, vacations, savings, or even invested in the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price. for better returns.
Frequently Asked Questions (FAQs)
When an individual earns more than what is required for settling his taxes and other necessities like insurance, loans, and other unavoidable living expenses, the excess amount exemplifies the individual’s discretionary income.
Discretionary income is the income available to an entity or person after paying or saving for taxes and unavoidable essential expenses like food, utilities, mortgages, and insurance. It is derived by deducting taxes and essential expenses from gross income or deducting essential expenses from disposable income.
People can spend it on discretionary items or activities like vacations, purchasing designer clothing, enjoying dining out. However, it is fairly practical only when people have appreciable earnings. It also depends on the portion they get to save as discretionary, that is, whether it is a significant amount or not.
This has been a guide to Discretionary Income and its definition. Here we discuss how to calculate it using a formula and example and its differences from Disposable Income. You may learn more about financing from the following articles –
- Consumer DiscretionaryConsumer DiscretionaryConsumer discretionary refers to goods and services mostly acquired using discretionary income as they are optional in people’s lives such as designer clothes or luxury cars.
- Disposable Income FormulaDisposable Income FormulaDisposable Income is the amount of money available after accounting for income taxes, either to spend or save the same. Disposable Income = PI – PIT, where, PI = personal income and PIT = personal income tax.
- Price SkimmingPrice SkimmingPrice skimming refers to a pricing strategy where the producers sell new, innovative, or improvised products or services at a high price for a short period targeting high-end customers and subsequently, reduces the price to tap remaining market segments.