What Is Discretionary Income?

127

“Discretionary income” is an interesting legal term from the Internal Revenue Code. “Discretionary income” means any income that isn’t included in the year’s income tax deductions. So, for example, if you earn fifty thousand dollars in a year and pay taxes on only forty thousand dollars, you would have earned fifty thousand dollars minus the applicable tax withholdings which would be forty thousand dollars. The net after-tax income would be sixty thousand dollars.

We are not talking about regular income here. We are talking about pre-tax income. When you file your taxes, your main form of “discretionary income” is interest and dividends. This is because these forms of income are exempt from tax payments and so are not taxable in the eyes of the Internal Revenue Code.

You need to understand, though, that tax payments make up a very large part of our total personal income. As such, you need to look very carefully at what you spend your money on. For example, if you spend ten thousand dollars on a new car, you might have paid three thousand dollars in taxes and you might have had this car for four or five years. It seems trivial, but it does matter. In the end, how you use your “free money” makes a big difference in your net worth and therefore your net personal income.

In today’s economic climate many people are confused as to what is discretionary income. There are some well meaning folks that actually believe that all income is disposable. Unfortunately, that’s just not the case. In fact, one of the first steps in building wealth is to identify your true earning potential. By determining your true earning potential you can then determine the amount of money that you will need to spend on entertainment, education, shelter and other items. Without knowing what your true earning potential is you are destined for living the financially insecure life of living off of handouts.

If the money you earn is to be used for purely consumption purposes, such as eating out at restaurants, or paying for entertainment activities the resulting expenditure will not reduce your disposable income. Your income is disposable only until it is spent. Once your income has been used for consumption it is no longer available to you. The money used to purchase necessities and to invest in an IRA should be considered as income since it represents a return on investment.

A saving plan is one method of having extra income. Typically, any additional money saved by a person will be taxed such as capital gains, dividends and interest. This is why savings accounts are typically under the tax bracket of IRA.

A person who is self-employed will have different needs than the typical worker. Self-employed individuals are allowed to save more than the typical individual. In some cases a person may choose to invest their extra income to save for retirement. Most banks will match a certain percentage of the savings. If the money is invested in low risk high yielding assets such as certificates of deposit (CD) it can provide excellent savings. If the money is invested in stocks or bonds the return will also be good.

Some self-employed persons also choose to utilize the funds for travel, expenses and entertainment. As long as the money is not used for business-related expenses the account can be rolled over into another account with better rates. When investing in the stock market, the person can make a very good profit when the market is good and let it fluctuate. However, when there is a downturn the person can lose money since the investments made were for a good market.

Discretionary income is the money that a person does not need to spend on anything. It is money that is left over after all expenses have been paid. It represents the opposite of a savings account. The tax treatment for saving this type of income will depend on the tax brackets of each individual. The money that is not required to be paid tax can be invested for higher yields or saved in a certificate of deposit.

For a person who has a job that is steady they may not need to save much for retirement. After the person has reached their career peak saving will not be necessary. For those people who have jobs that are unstable and are on a decreasing salary, saving will need to be done. A percentage of the salary will have to go toward savings for the retirement account.

Understanding what is discretionary income and its effects on your taxes will help you determine if saving for retirement is important or not. If you are earning enough but not putting away much, you will still have plenty left over after your expenses for the week are covered. If your income is going down just a little bit each month, you may want to start saving because it will make a difference after you retire. By knowing what is discretionary income you will be able to choose the best method of saving for your future.