In personal finance, the terms disposable income and discretionary income are sometimes used interchangeably, but they are different, which can be confusing. As a guide, in a budget disposable income is what an individual has to spend after paying the government, and discretionary income is what is left after the government and cost of living is accounted for.
According to Encyclopedia Britannica, disposable income is that portion of an individual’s income over which the recipient has complete discretion. In economic terms, it is an individual’s personal income less required personal income taxes and government fees (social security, medicare). The point is that an individual has no discretion over whether to pay government taxes and fees; they are required to by law even if how much is paid is up for debate.
The issue arises around the term “discretion” in the definition. There are some costs that an individual has limited discretion over, such as basic costs of living or personal necessities (food, shelter, clothing). These costs must be paid for even if the amount spent or what is deemed “necessary” is up to the individual. Here is where the definition of disposable income versus discretionary income comes into question.
In the US, personal disposable income is a factor in calculating GDP (gross domestic product). For this reason government bureaus such as the U.S. Census Bureau (which publishes data, including national disposable income information) and the U.S. Bureau of Labor and Statistics (which publishes the Consumer Expenditure Survey) use the basic formula of personal income minus personal taxes and government fees to define disposable income. They use the term discretionary income to define what is left of disposable income after personal necessities (bills) are subtracted simply because what are deemed personal necessities is so variable.
At a government and business level the distinction is clear, but in the personal finance arena the two are often used interchangeably depending on which books you read. In essence, the precise meaning will be defined by the context in which the terms are presented.
How an individual wishes to define disposable income for the purposes of a personal budget is a choice but for our purposes we will follow the economic definition.
It is easiest to think of disposable income in these terms. An individual receives a Gross wage of $800 a week, his net wage or what he takes home is $600 a week, after taxes etc. This is his disposable income.
Gross personal income – personal taxes = (net) disposable income.
This individual has recurring weekly expenses of $400 per week that include his rent, utilities, car payment, gas money and cell phone bill. This leaves him $200, or his discretionary income.
(Net) disposable income – personal necessities = discretionary income.
This discretionary income of $200 then covers savings, entertainment, vacations and so on. All the things that make life more interesting.
Although the terms are often used interchangeably, there is a difference between disposable income and discretionary income. Though, how an individual applies these terms to their personal budget is up to them.