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What is Disposable Income

definition

Disposable income is the difference between an individual’s salary and the amount they pay in local, state, and federal taxes.

🤔 Understanding Disposable Income

Many people use the two terms disposable income and discretionary income interchangeably, but the two are quite different. Discretionary income is the amount you have left to spend on non-essential items. Disposable income — or disposable personal income (DPI) — on the other hand, is the total amount of money you make after you pay your taxes. It’s also known as net pay or take-home pay. It’s the amount of money your family has to live on. Disposable income is an important indicator of how the economy is doing. Not only does it tell us how families are doing financially, but it tells us how much money they can put back into the economy through consumer spending.

example

Suppose Regina has a job where she makes a salary of $50,000. About 20% of Regina’s income goes toward income tax and other federal state and local taxes — This amounts to $10,000 of Regina’s income. Once 20% for taxes comes out, Regina has a take-home pay, or disposable income, of $40,000 per year. This amount is the money Regina will use to pay for all of her bills, savings, debt payments, and discretionary spending.

Takeaway

Calculating your disposable income is like when the doctor takes your blood pressure…

Whenever you go to the doctor’s office, the nurse or doctor takes your blood pressure. They use that as an indicator of your overall health. And just like your blood pressure is an indicator of your physical health, your disposable personal income is an indicator of your family’s financial health.

Tell me more...

What counts as disposable income?
Why is disposable income important?
What is the difference between disposable income and discretionary income?
What is a reasonable disposable income?
What is the disposable income by country?

What counts as disposable income?

Disposable income is the amount of money that you have left after subtracting local, state, and federal taxes as well as other mandatory deductions from your paycheck. The taxes that come out of your paycheck likely include income tax, as well as payroll taxes such as the Social Security tax and Medicare tax (which together make up FICA taxes).

A mandatory deduction is anything that the law requires your employer to withhold from your paycheck. So, while this certainly includes your taxes, it could also include other deductions such as court-ordered child support payments.

Other money comes out of your income before it hits your paycheck, too, but the money is still a part of your disposable income. For example, your employer might deduct the contributions for your 401(k) plan, health insurance, or a health savings account (HSA) directly from your paycheck. But because those are not mandatory deductions, they are still a part of your disposable income.

The formula for disposable income looks like this:

Disposable Income = Salary – (Taxes + Mandatory Deductions)

Many people think the term disposable income refers to the money they have left after paying their bills every month. And despite what the name suggests, that is not the case. All of the money you have to spend after taxes is disposable income, even the money going toward rent and other necessary bills. The money left over after paying for necessities is properly called discretionary income.

Why is disposable income important?

Disposable income is critical on both a micro and macro level. First, let’s talk about why disposable income is important to an individual or family.

Disposable income is the amount of money that a family has to live on. This is what they have to pay for all of their living expenses, including necessities such as food and housing. The more disposable income a household has, the more comfortably they can live and care for their family.

Disposable income also has more significant implications outside the household. First, disposable income is one of three key income measures the Bureau of Economic Analysis looks at, along with national income and personal pre-tax income.

Disposable income helps determine consumer spending, which is a determining factor of the consumer price index (CPI) —The CPI measures the prices of goods and services across the country.

Disposable income is also something the government might consider when setting fiscal policy. For example, if disposable income (and therefore, consumer spending) has gone down, then the government might try to find ways to grow the economy. They might do this through tax cuts or increased government spending. When taxes go down, individuals are spending less of their income on taxes. This results in disposable income going up.

What is the difference between disposable income and discretionary income?

Many people use the terms disposable income and discretionary income interchangeably, but they’re quite different. Your disposable income is the money you have left after taxes. This income is the money you have available to spend, save, and invest. The two factors that determine this number are your income and the amount you pay in taxes (plus any other mandatory deductions from your paycheck).

Discretionary income, on the other hand, is the amount of money you have left after you’ve funded your necessities. Necessities are your housing, transportation, food, utilities, debt payments, and other bills your family pays.

The formula for discretionary income looks like this:

Discretionary Income = Disposable Income – Necessities

Your discretionary income could be the money that you spend on non-essentials like travel, restaurants, and recreational activities. It also includes any money you put into savings or investment accounts.

We’ve outlined why disposable income is important both to a household and to the economy. Discretionary income matters as well. Not only can more discretionary income increase quality of life, but having money to put into savings and retirement accounts can help create a secure future.

Discretionary income varies widely across different income levels. One study of spending looked at how much discretionary income families had after accounting for necessities. The results show that low-income families making $15K–$20K spend 98% of their disposable income on necessities, meaning they often had just a couple of thousand dollars left for an entire year of discretionary spending. This number leaves little for saving in an emergency fund or retirement account.

On the other hand, individuals making more than $150,000 annually still had about 40% of their income left as discretionary income, meaning that they had over $50,000 per year for non-necessities.

On a larger scale, the amount of discretionary income that families have helps to determine consumer spending — And consumer spending is one of the most critical indicators of a healthy economy. Consumer spending helps to determine the country’s gross domestic product (the GDP is an economic snapshot of the economy for a particular period).

It also impacts overall inflation. Reduced spending (aka reduced demand) means that prices fall. Falling prices could lead to falling wages. When this happens, the country experiences deflation. So, generally speaking, the government likes it when people have discretionary money to spend.

What is a reasonable disposable income?

There’s no easy answer for what is a reasonable disposable income. It certainly depends on the financial obligations of a particular family. Those with dependents will likely require a higher disposable income to live comfortably.

According to data from the U.S. Census Bureau, the median family income in 2018 was $63,179. This number is up by over $7,000 from 2012. However, this number does not represent just disposable income — It includes all income before taxes.

The Organization for Economic Cooperation and Development (OECD) is an international organization with 34 member countries, including the United States. The OECD reports that the average household disposable income in the United States is $42,284.

This amount is the highest of any other country in the OECD. But the United States also has the most substantial income gap between the rich and poor of all of the countries in the OECD — This could create some misleading data.

One number we could look at for guidance as to what is a reasonable disposable income is the U.S. poverty level. The Department of Health and Human Services determines the poverty level annually. This income level determines which families are eligible for certain government subsidies (often these are available to any family with a household income of 150% of the poverty level or less). The 2020 poverty level for a household of four is $26,200.

One could probably assume that the Department of Health and Human Services believes that anything below the poverty level is not a reasonable disposable income, which is why those individuals are eligible for certain government programs.

What is the disposable income by country?

The Organization for Economic Cooperation and Development (OECD) tracks the average household disposable income for its 34 member countries, including the United States. As of 2019, the average house disposable income for those 34 countries was $33,604.

The OECD did not have data for every member country, but the United States had the highest household disposable income of reporting countries, with an average of $45,284. The reporting country with the lowest household disposable income was Greece, with an average of $17,700.

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