Disposable income is an often-misunderstood term. It suggests we have “disposable” money that we really don’t care about. But the truth is, most of us care about every penny of it, and many of us can’t afford to waste any money.
This is why it’s always a good idea to understand what disposable income is. Understanding how much disposable income you have can help you improve your budget.
SEE: [50 Ways to Improve Your Finances in 2019.]
What is disposable income?
Disposable income is money left over after taxes are taken out of your paycheck. That means your mortgage or rent, crazy as it may sound, is part of your disposable income.
That said, many people define disposable income as the money you have left over after taxes — and after you’ve paid the bills that you have to pay, such as a mortgage, car payment, student loans and the electric bill.
Guy Penn, a fiduciary investment adviser and the owner of St. Louis Private Advisors, agrees. “Disposable is somewhat subjective, so it doesn’t lend itself well to a hard formula,” Penn says. In general, he says his firm defines disposable income as net income minus fixed recurring expenses, minus short-term emergency savings and long-term investment savings.
Disposable versus discretionary income
You’ll also hear people talk about discretionary income, which is a subset of disposable income. It’s almost the same thing, and sometimes the terms are used interchangeably. While disposable income represents your income after taxes, discretionary income refers to the money left over after taxes and your necessities, like groceries and rent. You decide how to use this money to invest, save and spend at your discretion.
How to calculate your disposable income
In theory, it should be easy: Take your paycheck after taxes and subtract your bills from it. Divide that amount by 7 or 14 days or whatever your pay period is. What’s left over is the amount you can spend every day.
That said, some experts suggest compiling a yearly budget and adding up everything you spend during the year on your mortgage, car payments, student loans and so on. Once you’ve figured out your annual budget for everything you likely have to spend money on, including groceries and gas, whatever is left over is your annual disposable income. From there, to make the number more manageable, you can divide it by 12 (months) or 365 (days).
You may want to try both approaches. If nothing else, the more you understand what you’re spending money on, the better.
[SEE: 9 Ways to Live Well and Spend Less in 2019.]
Factors to consider when calculating disposable income:
— Disposable income can vary from month to month. For instance, if you look at your expenses for your next pay period and calculate how much is left over each day, “not every pay period would have the same disposable income,” says Liz Crystal, owner of the LC Group, a daily money management, personal bookkeeping and consulting services firm in Green Brook, New Jersey. After all, your expenses won’t be the same each pay period. During the first pay period, you may pay your mortgage and water bill, and during the second pay period, you may have to cover your car insurance or student loans. Your variable expenses likely change, too. Not everyone spends the same amount on groceries from week to week, for example.
— Savings should be taken into account. Before calculating your disposable income, Crystal suggests subtracting money for savings, such as your retirement and emergency fund. It’s the “pay yourself first” mantra. Otherwise, you may end up spending all of your disposable income and saving nothing.
— Think long term and be realistic. Be careful not to put too much weight on one number, says Kelan Kline, who runs the finance and lifestyle blog The Savvy Couple, with his wife Brittany. “The biggest thing to consider when calculating your disposable income is being realistic with yourself. Just because your yearly budget says you have an extra $10,000 left at the end of the year does not mean you should start living like a high roller,” he says. “You need to think long term and understand things like car repairs, taxes, a death in the family and so on are going to happen at some point.”
And, of course, $10,000 in disposable income — just an example Kline pulled out of thin air — is not that much once you start looking at it on a daily basis. That’s only $27 a day.
[SEE: 15 Little Things That Impact Your Finances]
So for whatever disposable income amount you determine that you have to spend per day or week or throughout the year, Kline suggests that you plan on spending 10 to 15 percent more than you think you will. Or put 10 to 15 percent away to go toward that disposable income if you need it.
“This allows us to have a nice cushion and not have to worry about money throughout the year,” he says.
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How to Determine Your Disposable Income originally appeared on usnews.com
