Disposable Income

Have questions about what disposable income is and how to calculate it? Good news, you found the right resource to learn all about disposable income, how it is different from discretionary income, and much more!

What is Disposable Income?

Disposable income, also known as personal disposable income (DPI), refers to the money left for an individual or family to spend after taxes. It denotes the actual income available for spending after all mandatory deductions and taxes. Mathematically, the calculation is defined as follows:

Disposable income = Personal income – Personal income taxes

For example, if a person has a personal income of $10,000 and pays $2,000 in taxes, their disposable income would be $8,000.

Disposable income as an economic concept is essential as it gives insights to individuals and guides them in making sound financial decisions and expensing for months to come based on their net income.

Why is it Important to Track Disposable Income?

Disposable income is essential both from an individual’s perspective and the economy as a whole. It helps with the following financial activities:

• Assess financial health: Disposal income helps an individual or household understand how much they spend compared to earnings, which helps manage one’s resources.
  If the saved amount of disposable income dips drastically, it can indicate overspending, and necessary corrective measures should be placed in order.
• Plan and make sound decisions: Disposable income is helpful not only to track spending and avoid unwanted expenses but also to help with planning investments and making informed decisions about one’s finances.
  This, in turn, helps to remain disciplined for goals such as buying a new house or fulfilling existing loans.
• Avoid debts and liabilities: When one loses sight of spending against their earning capacity, it is one of the surest ways towards debts, liabilities, and bankruptcy.

Tracking disposable income makes it easier to pinpoint the areas where unwanted expenses are creeping in and avoid getting into a cycle of borrowing and debts.

How to Calculate Disposable Income?

Disposable income is the net amount available for spending after tax deductions. Although the simple formula for this income talks about subtracting taxes and deductions from earnings.

This valuable process starts with adding up one’s gross income and then subtracting the allowed deductions before calculating how much federal income tax is still owed. First, let’s define what gross income and taxes are.

• Gross income: this is the total income an individual or household earns before any deductions.
• Taxes: The federal income tax which we are required to file each year. there can be other forms of taxation that the household or individual might be liable to pay, such as county property tax or state auto tax.

Items that can be deducted to lower taxes include the following:

• Social Security Contributions: In some countries like the U.S., a portion of the income is used to contribute to Social Security or similar social programs.
• Retirement Contributions: 401(k) or an Individual Retirement Account (IRA) are standard components of retirement savings plans and are usually deducted from gross income.
• Insurance: If your total medical expenses surpass 7.5% of your gross annual income (AGI), federal law allows you to deduct the amount you spent on premium and copay costs from your taxable income.

What is the Difference Between Disposable and Discretionary Income?

Although the terms disposable income and discretionary income are used interchangeably, they denote two distinct concepts of an individual’s income.

Disposable income is what a person has available to spend after tax deductions such as income tax, social security contributions, etc. This income can be used to spend, invest, or save.

On the contrary, discretionary income is what remains with an individual after basic needs and sustenance expenses such as rent, food, utilities, and the like.

This income is used for non-essential items such as entertainment, dining out, travel, and more, or in other words, reserved for the discretion of the individual and hence the name.

Disposable income is an indicator of a person’s purchasing power.

In contrast, discretionary income indicates a person’s ability to raise their current standard of living (the degree of wealth and material comfort available to a person based on economic class and region).

If you plan to invest and save money, reducing unwanted expenses and raising your discretionary income is necessary.

A common way for employees looking to meet a personal goal of buying a new house or car is to increase their disposable income, which involves asking for a raise or looking for a higher-paying job.

What is the Difference Between Personal Income and Disposable Income?

Personal income is the total earnings an individual receives in a specific period from various sources such as salaries, benefits, dividends, stocks, interests, and more. After taxes are taken from earnings, what remains is disposable income.

Thus, you can identify disposable income after deducting taxes from your personal income.

How to Invest Disposable Income?

One of the most common pieces of advice you may receive for disposable income investment would be to create a financial goals plan.

Generally, the following concepts apply to people who wish to save money and grow their wealth over a long period.

You should speak with a licensed financial advisor and tax planner before making investing decisions. Your unique financial situation will dictate the best wealth-growing route to take.

Below are common strategies financial professionals tell their clients for how they can effectively grow and invest their disposable income.

• Clear any existing debts: Ensuring you have no financial obligation is empowering and helps you lead a life with less stress. Debts that incur high interest can erode wealth quickly and negatively affect one’s financial profile.
• Build emergency funds: In a volatile global economy, the job market isn’t as steady and reliable as it once was. An emergency fund can act as a safety net for sustenance for demanding situations such as losing one’s job or medical exigency.
  Ensure you save routinely to accumulate this fund for any future needs.
• Diversify investments: Don’t put all your eggs in a single basket- invest across different mediums, such as mutual funds, stocks, bonds, real estate, etc., to grow. This will not only reduce overall risk but also will help you modify investments based on returns.
• Save for Retirement: For a stress-free retirement, it’s a good practice to start saving early on. You can utilize retirement-specific plans such as 401(k)s or IRAs that can also offer tax relief and benefits.

As your wealth increases, seeking professional advice from a financial advisor to help you with a personalized investment strategy is commonly recommended.

How Does Disposable Income Affect the Economy?

Disposable income is crucial both from an individual’s perspective and for the economy as a whole. From the lens of the overall economy, many indicators come into light when we analyze how disposable income affects the economy.

• Fluctuations in disposable income can directly impact income tax laws, employment rates, wages policy, and more. A lower disposable income might be indicative of a slow or stagnant economy.
• The standard of living in countries with higher disposable incomes tends to be higher.

This metric plays a vital role in business strategy and market research to determine customer behaviors and consumption patterns.

Disposable income may also have impacts on inflation rates. When more income is available for spending, people consume more goods and services, which may lead to increased demand and prices.

How Does Disposable Income for Garnishment Work?

The term garnishment refers to the legal process in which an employer withholds a portion of one’s wages to pay off an unfulfilled debt or financial obligation. The garnishment is paid from a portion of the debtor’s wages, earnings, or assets.

The funds can be withheld by an employer or financial institution or seized by a third-party entity.

The amount of disposable income for garnishment depends on the state and jurisdiction as it varies from one to another and also on the type of debt.

For instance, the garnishment laws for child support debt in Texas can be up to 50% of a parent’s disposable income, whereas in Florida, that percentage can be as high as 65%. The following are examples of debts that garnishment liens can be used to pay:

• Child Support and Alimony: 33% to 50% of disposable income can be garnished for alimony and child support.
• Consumer Debts: For debts owed to non-government credits, such as credit card debt, unpaid medical bills, and the like, either 25% of the individual’s disposable income or the amount by which the individual’s disposable income exceeds 30 times the federal minimum wage can be garnished. These amounts are set by federal law.
• Student Loans: Up to 15% of disposable income can be garnished.

Is Social Security Considered Disposable Income in Chapter 7?

No, Social Security income is not considered disposable income according to Chapter 7 bankruptcy. This implies that if you file for Chapter 7 bankruptcy and get Social Security funds, you will not be able to utilize those benefits to repay your outstanding debts.

Under 11 USC 101(10A)(B), the Bankruptcy Code expressly prohibits Social Security benefits from being deemed disposable income in Chapter 7 bankruptcy proceedings.

Your disposable income will instead be determined by your other sources of income, such as salary, dividends, and interest.

Thus, even while going through a bankruptcy procedure, people can continue to satisfy their fundamental necessities and maintain a minimum level of living.

The exception to this rule is if you receive Social Security disability benefits and have dependents without Social Security benefits, then this can be considered as disposable income from a bankruptcy perspective if the benefits are used to help pay for family-related expenses, like rent.

When your income sources combined with the money from your Social Security benefits exceeds the median household income in the U.S., it can cause any extra amount to be considered disposable income. That means that income may need to be disclosed in your bankruptcy schedule.

Is a 401K Part of Disposable Income?

No, 401(k) contributions are not part of disposable income as they are considered savings. Contributions to a 401(k), company-sponsored retirement account are made from gross income, i.e., with pre-tax money. That means they are subtracted from your gross income before tax computation.

Lowering your taxable income can result in tax savings. However, it also means your 401(k) contributions don’t count as a portion of your discretionary income.

While 401(k) contributions are not considered discretionary income, it is crucial to understand that annual limitations exist on how much an individual can contribute to their 401(k).

The IRS determines the contribution caps, which are subject to change each year. The early withdrawal of funds from a 401(k) before retirement age is also subject to penalties, barring certain extenuating circumstances.

How Much Disposable Income Does the Average American Have?

According to the U.S. Bureau of Economic Analysis, the average disposable personal income in the U.S. dropped to $55,781. That is a $307 dip from the 2021 average of $56,088. As of June 2023, the average disposal income amount for Americans is $58,947.