What is the disposable income?
In the field of personal finance, disposable income refers to all of an individual’s remaining income after accounting for taxes and other mandatory payments. In other words, it is a person’s net income – what they earn after taxes.
Disposable income is a bit of a misnomer, because it can’t be spent at all—in most cases, it’s used first and foremost to pay for necessities like housing, food, health care, and transportation. Then, if any is left over, it can be used for more discretionary expenses like vacations, sports equipment, and entertainment.
How to calculate disposable income
Disposable income is calculated by subtracting taxes and any other mandatory contributions (such as 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 a person earns before anything, including taxes, is deducted. Since disposable income represents income after taxes, an individual’s disposable income is always smaller than his total income (or the same, if he is exempt from taxation due to his level of income).
Disposable Income vs. Discretionary Income: What’s the Difference?
Discretionary income is a category that falls under disposable income. After taxes, an individual’s income can be used for both necessities (such as food and housing) and discretionary purchases (such as 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 the remainder of disposable income after necessities are paid. For example, an individual’s monthly discretionary income would be whatever they have left after paying rent, utilities, healthcare, food, and transportation.
How is disposable income used in personal finance?
The lower a person’s disposable income, the less discretionary income he is likely to have because his monthly necessities may cost roughly as much as he earns in a month. As disposable income increases, so does discretionary income, which can either be spent on products and services or saved.
Thus, individuals with a higher disposable income have a higher marginal propensity to save (how much someone will save for each additional dollar of income) and a higher marginal propensity to consume (how much an individual will spend for each additional dollar of income).
How is disposable income used in macroeconomics?
Changes in average disposable income are closely watched by both the Federal Reserve and the Bureau of Economic Analysis. A decline in average disposable income can indicate economic decline and even recession, while a rise in average disposable income may be a reflection of a healthy economy. When people earn more money, they spend and invest more money, which helps GDP growth and acts as a boon for companies and their stocks.
Companies in so-called “discretionary” industries (such as jewelry, entertainment, and travel) also monitor 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 after paying for their basic necessities, the more likely they are to spend it on things like collectibles, sports equipment, massages, and other non-essential expenses. When average disposable income falls, companies that sell discretionary goods and services tend to see their dividends (and, as a result, their stock prices shrink).
Disposable income, wages and child support
When someone owes money as a result of not paying their tax bill or child support, the government may, through a court order, require the employer to withhold some of their paychecks so that they can be diverted toward paying off the debt.
When an individual’s pay is withheld, his or her disposable income is often used to calculate the amount that might be deducted from each paycheck. Generally, the amount withheld may not exceed 25% of an individual’s disposable income or the amount whose weekly income exceeds 30 times the federal minimum wage of $7.25 per hour – whichever is less.