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What is Disposable Income and What Should You Do With It?

Disposable Income

Budgeting

What is Disposable Income and What Should You Do With It?

Despite its name, disposable income isn’t money you throw away in the trash (although you can). Disposable income is the amount of money you have remaining each paycheck after your taxes and pension fund contributions have been withheld. You can spend your disposable income however you want, but, we give you some ideas so your money isn’t going into the proverbial trash can.

What Exactly Is Disposable Income?

This might be the first time you have ever heard the term disposable income before. If so, that’s okay. The important thing to know is that you earn this type of income with each paycheck, even if you didn’t know there was a name for it. Maybe you call it “spending money.”

Before we discuss how you should spend your disposable income, let’s first find out how much disposable income you have every month.

If you work for an employer, you receive a check at least once a month. If you’re a W-2 employee, your employer withholds taxes from your check. Even though you earn $3,000 every month, only $2,250 is deposited into your bank account. That’s because the first portion of each check is automatically withheld to pay your federal income tax, Social Security contribution, and state income taxes.

Once your taxes have been paid, your paycheck or direct deposit amount is called your “net income.” You use this money to pay the rest of your bills each month including:

  • Health Insurance (Your employer might withhold)
  • 401k plan contributions (Your employer might withhold)
  • Loan payments (Home, auto, student loans, credit cards)
  • Utility bills
  • Insurance (Homeowner’s, Auto, Life)
  • Non-retirement investments
  • Savings
  • Groceries
  • Gas
  • Cell phone
  • Cable TV
  • Vacation
  • Many other monthly expenses

While it’s not an exhaustive list, you get the point. There are many different things you spend your money on each month.

How to Maximize Your Disposable Income

You still might be thinking that not all of your disposable income is exactly “disposable” right? After all, you need to live somewhere and you have other necessary expenses like health insurance, groceries, and buying gas so you can continue to work. You’re correct.

Distinguish Necessary Expenses from Optional Expenses

Certain monthly expenses are non-negotiable. You might be required to carry health insurance through your employer because of current federal law. Or, you might have to pay garnished wages, alimony, or child support. All this money can be automatically withheld by your employer to ensure you don’t spend the rest of your paycheck on something else first.

After taxes are withheld from your salary, subtract any other required expenses from your paycheck. For instance, your monthly healthcare premium might be $300. Of the $2,250 your employer gave you after taxes, you really only have $1,950 a month to spend on everything else. That means your monthly expenses must be below $1,950 or you go into debt.

You Still Have Some Control on Necessary Expenses

Here are five mandatory expenses that you should budget for:

  • Insurance
  • Home Mortgage Payment or Rent
  • Food
  • Retirement
  • Current debt payments (credit card bills, student loans, auto loans, etc.)

Depending on where you live, you will only have so much control over how much your monthly rent payment is. It will probably always be cheaper to rent an apartment in Toledo, Ohio than in downtown New York City. While you should never compromise your personal safety, you can choose to buy a less expensive house or rent a cheaper apartment. Yes, you may need to upgrade in a few years when your financial situation improves, but, you will have more money (i.e. disposable income) now to pay the rest of your bills.

We all need to eat, and you can also save money on groceries as well. The easiest way is to simply pack your lunch and prepare your own food as much as possible. When the average sit-down restaurant meal can cost $10-$20 per plate that you can make for $3 or less, you can easily save hundreds of dollars a month by making your own food.

Insurance is another non-negotiable. If you have a home mortgage or car loan, you will be required to have certain coverage amounts by the lender to protect their asset. Once you repay the loan, you can raise your deductible or cancel certain types of coverage, but, you should still have some sort of homeowner’s or automobile insurance. You can also save money by comparing price quotes from different insurance providers.

You might be surprised to see retirement on the list. By making these two items a priority, you actually do yourself a favor. Saving a small percentage for retirement will help ensure you have a nest egg so you can afford to retire at a reasonable age.

How To Manage Your Non-Essential Spending

What makes your disposable income extremely valuable is that the decisions you make today can open future doors of opportunity you never imagined.

Even though your options to limit essential spending might be slim, you will have more options when it comes to non-essential spending. The money you have leftover after paying your taxes and necessary expenses might be the true version of your disposable income.

Let’s say you have $700 remaining after your required monthly bills are paid in full. You can truly do whatever you want with this money and not suffer any financial consequences.

Here are a few things you can spend your money on:

  • Cable tv
  • Buying concert tickets
  • Making extra loan payments
  • Saving for vacation
  • Putting extra money into your savings or retirement account

Use this portion of your income to have fun, after all we work hard to afford luxuries that we wouldn’t have by not working. Just be sure you do not confuse your non-essential spending with essential spending. If you don’t have money to take a lavish vacation, you will survive. Take a cheaper trip this summer and try to save enough to go next year.

You may also decide to make extra loan payments or put extra money into your savings and investment accounts. While you won’t have as much money to spend on entertainment and fun today, you will save thousands of dollars in interest payments which means you will have more money to spend on non-essential expenses in the future because your loans will be paid off early. By making one extra loan payment a year on a 30-year mortgage you can repay your loan three years early and save $20,000 in interest ($250,000 house @ 3.25% interest).

How awesome is that?

Summary

We all earn a disposable income, but, each one of us spends it differently. While you can spend your money however you want, keep in mind that the decisions you make today can greatly improve your future financial health.

How can you optimize your disposable income? 

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