When creating a budget and setting financial goals for yourself, its important to know how much money youre working with. Spoiler: its not the number on your bi-weekly pay stubits your disposable income.
Your disposable income is the amount that you have available to spend once Uncle Sam has gotten his cut. Lets 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 youve 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 that 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 liferent, 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 elses, and will likely change throughout the course of your life as your financial circumstances change. Heres 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 youre self-employed, you wont have an employer to do the heavy-lifting of withholding taxes for you. Youll 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. Thats the money you have leftover 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 youre bringing in and how to best allocate those funds, you can ensure that youll be able to weather any financial setback that comes your way and hit all of your major money goals.
