When it comes to how much money you earn, not all of it is created equal. Some goes straight to the tax man in the form of federal and state taxes, local taxes and payroll deductions. Most people prioritize what's left to essential expenses such as housing, groceries and utilities. It's only after you've paid necessary living expenses that you get to the next tranche of cash, which is known as discretionary income.
TL;DR (Too Long; Didn't Read)
Discretionary income is how much money a consumer has left over each month after taxes and essential spending are covered.
Discretionary Income Explained
Discretionary income is the amount of money a person has left over after paying all necessary taxes and survival expenses such as housing costs, food, transportation, utilities and medicine. A consumer may think of it as the amount available for spending on "luxury" items such as vacations, movies and consumer electronics. It's called "discretionary" because you have control over how you spend this money – it isn't committed to mandatory living expenses.
Discretionary Income Example
For most people, discretionary income is the first to shrink when a pay reduction happens. For example, if someone makes $5,000 per month after taxes and has $2,500 in bills and other necessary expenses, she has $2,500 in discretionary income. If she takes a pay cut to $4,000 per month, her essential costs stay the same, but she only has $1,500 left over in discretionary income. It's likely that the consumer will cut her discretionary spending or use credit cards to make additional purchases beyond what she can afford.
Why It Matters to Businesses
If you're a business that sells nonessential goods like vacations or entertainment, then a high level of discretionary income in the economy is vital to the financial health of your business. Luxury goods suppliers are far more likely to suffer during economic downturns than a business selling necessities because consumers stop spending on luxury items first. Other factors that might lower a consumer's discretionary spending power include tax increases, higher interest rates that push up housing costs and high fuel prices.
Discretionary Income vs. Disposable Income
Although the terms "discretionary income" and "disposable income" are sometimes used interchangeably, they are different things. Disposable income is a person's after-tax income. It's the amount he takes home after paying federal and state income taxes and payroll taxes. Consumers can use that money to pay both mandatory and nonmandatory expenses. Discretionary income is also after-tax income, but it subtracts necessary living expenses such as groceries, rent and utilities. Discretionary income is always lower than disposable income because you are deducting all the amounts needed to meet necessary bills.
How to List Discretionary Income on Tax Forms
Discretionary income isn't especially relevant to tax forms, except to the extent that a discretionary expense qualifies as an itemized deduction, whittling down the gross income on which tax is assessed. For business owners, some of the most common itemized deductions in this category are business entertainment and charitable donations. To itemize, you need to list each item on Schedule A, which is part of Form 1040.
Jayne Thompson earned an LL.B. in Law and Business Administration from the University of Birmingham and an LL.M. in International Law from the University of East London. She practiced in various “Big Law” firms before launching a career as a business writer. Her articles have appeared on numerous business sites including Typefinder, Women in Business, Startwire and Indeed.com.