Disposable income is used to pay for both necessities, save for retirement, and make discretionary purchases.
What Is Disposable Income?
In the realm of personal finance, disposable income refers to all of an individual’s income that is left over after taxes and other mandatory payments are accounted for. In other words, it is a person’s net income—what they make after taxes.
Disposable income is somewhat of a misnomer, as it isn’t really disposable at all—in most cases, it is used first and foremost to pay for necessities like housing, food, healthcare, and transportation. Then, if any is left over, it can be used for more discretionary expenditures like vacations, sporting equipment, and entertainment.
How to Calculate Disposable Income
Disposable income is calculated by subtracting taxes and any other mandatory contributions (like social security payments) from an individual’s gross income.
Disposable Income Formula
Disposable Income = Gross Income – Taxes and Other Mandatory Contributions
Disposable Income vs. Gross Income: What’s the Difference?
Gross income means total income, or what someone makes before anything, including taxes, is deducted. Since disposable income represents income after taxes, an individual’s disposable income is always smaller than their gross income (or the same, if they are exempt from taxes due to their income level).
Disposable Income vs. Discretionary Income: What’s the Difference?
Discretionary income is a category that falls within disposable income. After taxes are deducted, an individual’s income can be used for both necessities (like food and housing) and discretionary purchases (like movie tickets and charitable donations). Discretionary income is calculated by subtracting the cost of all necessities from an individual’s disposable income.
Discretionary income represents what remains from disposable income after necessities have been paid for. For instance, an individual’s monthly discretionary income would be whatever they have left over after their rent, utilities, healthcare, food, and transportation are paid for.
How Is Disposable Income Used in Personal Finance?
The lower someone’s disposable income, the less discretionary income they are likely to have because their monthly necessities may cost almost as much as they make in a month. As disposable income increases, though, so does discretionary income, which can either be spent on products and services or saved.
Individuals with higher disposable incomes, therefore, have a higher marginal propensity to save (how much more someone will save for every added dollar of income) and a higher marginal propensity to consume (how much more an individual will spend for every added dollar of income).
How Is Disposable Income Used in Macroeconomics?
Changes in average disposable income are closely monitored by both the Federal Reserve and the Bureau of Economic Analysis. Falling average disposable income can point toward economic decline and even recession, while rising average disposable income may be reflective of a healthy economy. When people make more money, they spend and invest more money, which helps to grow GDP and acts as a boon to companies and their stocks.
Companies in so-called “discretionary” industries (like jewelry, entertainment, and travel) also watch disposable income closely. As mentioned above, higher disposable income means higher discretionary income, and discretionary income is what consumers spend on non-essential products and services.
The more income someone has left over after their basic necessities are paid for, the more they are likely to spend on things like collectibles, sporting equipment, massages, and other non-necessary expenditures. When average disposable income falls, businesses that sell discretionary goods and services tend to see their profits (and as a result, their share prices) shrink.
Disposable Income, Wage Garnishing & Child Support
When someone owes money as a result of failing to pay their tax bill or child support, the government may, via a court order, require their employer to withhold some of their wages so that they can be diverted toward debt repayment.
When an individual’s wages are garnished, their disposable income is often used to calculate the amount that may be withheld from each paycheck. Generally, the amount garnished may not exceed 25% of the individual’s disposable income or the amount by which their weekly income exceeds 30 times the federal minimum wage of $7.25 per hour—whichever is lower.