Your Financial Health Depends on Knowing One Number: Discretionary Income

Most of us don’t have a lot of control over how much we pay for our mortgage or student loans, at least in the short run. But how many trips we eat out with friends or whether we splurge on a 60-inch TV? That’s a different story — and that’s where discretionary income comes into play.

The phrase financial gurus give to the part of your income that’s more want-based than need-based is “discretionary spending” or “discretionary income”. And for many of us, understanding that difference – and, more importantly, doing something about it — is the lynchpin of a sound financial plan.

In more concrete terms, discretionary income is the amount of your paycheck left over after accounting for income taxes and all those other necessities that eat away at your checkbook — things like home payments, electric bills and groceries. It’s not to be confused with “disposable income,” which, despite sounding like the same thing, is actually a very different category. The latter is the entire difference between your gross earnings and what you pay in taxes. Of course, that means it’s a much bigger number.

Say you bring in after-tax income of $4,000 a month, but pay $1,500 in rent, $300 in utilities, $400 on groceries, $200 in student loan bills and $100 on prescription medications. When you deduct all those needs, you’re left with $1,500 in discretionary income. Before taking all that cash and going on a massive binge session at the mall, though, keep in mind that you still haven’t saved anything yet. Yeah, that comes out of discretionary income, too – not just the fun stuff.

That’s why managing your discretionary income is such a key element of your financial well-being; it’s sharing the same slice of the pie as your emergency fund, retirement accounts and other savings vehicles. Today’s wants and tomorrow’s needs are locked in continual battle. Unfortunately, it’s all too easy to let the former win, which puts you on dangerous footing if you unexpectedly find a pink slip on your desk or hope to retire at a reasonable age.

Incidentally, the U.S. Department of Education uses discretionary income to determine how much to charge student loan borrowers who use income-driven repayment plans. But their definition is quite different than the one you would typically use for overall financial planning purposes.

For example, under the income-based repayment plan, the government considers your discretionary income to be your gross adjusted income minus 150 percent of the federal poverty level for a family your size. (L3) It expects you to pay a certain percentage of that each month toward your student loan balance. There’s a handy calculator on its website that lets you figure all that out.

Controlling What Goes Out

Let’s get back to the more traditional meaning, though. Why is discretionary spending so critical to your financial health? Simply put, the more of your money that’s spent on satisfying your ephemeral demands – the leather jacket or season tickets to your favorite baseball team – the less that’s going to be around for your future needs. “Most people don’t have a ton of control over what comes in, but they do have control over what goes out,” says Troy Zerveskes of New Hampshire-based Advisory Resource Group.

Of course, we’re all on this planet for a certain amount of time. And while money may not buy you happiness, it can certainly help pay for some good times along the way. So the point isn’t to engage in decades of deprivation in the name of a glorious retirement (although it might be the ticket to a great senior home one day). Instead, the idea is to find a happy middle, where your short-term wants don’t always get the upper hand.

Unfortunately, many of us aren’t very good at finding that golden mean. Consider the fact that 4 in 10 Americans couldn’t pay for an unexpected expense totaling $400 without pulling out their credit card, according to a Federal Reserve study last year. Or the Government Accountability Office’s finding that nearly half of adults 55 and older – yes, the folks who should be just a few years away from retirement – have absolutely nothing put away in a 401(k) or IRA. No, as a society we’re not very good at thinking long-term.

So here are a couple ways to get a check on your unnecessary spending. One is to simply pay your future self first. Every time you get a paycheck, it means immediately putting aside money for an emergency fund if you don’t have one already.

Divert another portion toward your retirement account, whether through a payroll deduction or automatic bank draft. If you began investing in your 20s, some financial planners say you’ll be in good shape contributing 10 percent of your income, although you’ll definitely want to kick it up a notch if you’re starting late or have dreams of a more lavish retirement.

With your future needs addressed right off the bat, anything left over after paying the important stuff – food, shelter, utilities – is yours. Suddenly, you don’t need to stress as much worrying about whether you can afford a trip to that nice steakhouse near home. You know you can afford it because the money’s still there after you’ve addressed those higher-order expenses.

Another strategy, suggests Zerveskes, is to dedicate a debit card to your discretionary expenses – or even a credit card, if you pay it down each month – so you get a broad picture of how much you’re spending on the non-essentials. “Whether you’re making $30,000 or a million, you have to look at where the money’s going,” he says.

Zerveskes says using plastic is a more convenient alternative to the traditional envelope system, where people would set aside separate amounts of cash for each expense category to avoid overspending. With most of us shopping online and using automatic bill pay features, he says, cards offer a more practical solution.

What’s more, some banks sort your transactions automatically, which can help you see what your biggest money traps are hidden. “Credit cards used to be a dirty word,” says Zerveskes. “But if used responsibly, they can be a really good tool to understand what you’re spending on.”

You may find that it isn’t the occasional shopping trip that’s really getting you into trouble, but the frequent lunches or lattes that keep adding up. “A lot of people are responsible about not buy big-ticket items, but five $20 items is still the same as one $100 item,” says Zerveskes. Having all those discretionary transactions on a separate account statement makes them a lot harder to hide.