Student Loan Repayment Plan: Disposable vs. Discretionary Income
- Disposable income is the same as “after-tax income."
- Discretionary income is essentially your disposable income minus the money you spend on necessities.
- Your discretionary income is used to calculate your income-driven repayment plan.
The terms disposable income and discretionary income get thrown around a lot, often incorrectly. So the question is, what do these words mean? Even deeper than that, why does it matter? Surprisingly, understanding the difference between these two very similar ideas is a key component of understanding federal student loan repayment.
What is Disposable Income?
Disposable income is the easiest to understand. It is simply the money you have left over after you’ve paid your taxes. This is also called “after-tax income” or net pay. According to the Bureau of Economic Analysis, it is simply “personal income minus personal current taxes.” To clarify, personal current taxes excludes things such as sales tax and even FICA (Federal Insurance Contributions Act) taxes.
How to Calculate Your Disposable Income
To calculate your disposable income, you must take your total salary minus your effective tax rate. For example, if you make $100,000, then you would be in the 24% tax bracket (if filing single). But because of the bracket system, your effective tax rate would be more like 15%. So to calculate your disposable income, you will simply take $100,000 – 15,000 (100,000 X .15) = $85,000.
Please note that your effective tax rate changes depending on how much you make, current tax brackets, deductions, and several other factors. You can find how much you paid in personal taxes by reviewing your tax returns.
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What is Discretionary Income?
Now that we understand disposable income, what is discretionary income? Isn’t that the same thing? While the words disposable and discretionary have similar meanings, the terms disposable income and discretionary income have two very distinct meanings, according to the United States government.
Discretionary income is the money you have left over after paying taxes and necessary expenses such as rent or mortgage, utilities, and groceries. It is discretionary because it is used to pay for the things that are nice to have and not the things necessary to survive. Think of the money in your paycheck as “needs and wants.” The discretionary portion of your income is the “wants” part.
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Why Does Discretionary Income Matter?
Discretionary income is used specifically as a metric of eligibility for the Income-Driven Repayment (IDR) Federal Student Loan Forgiveness Plans. The amount that you are expected to repay in various IDR plans is usually calculated as a percentage of your discretionary income. If you plan to sign up for an IDR plan to help pay down your student loan debt, here is what you can expect from the various IDR plans available to you.
Income-Driven Repayment Plans
PAYE (Pay As You Earn)
In the PAYE plan, you can generally expect to pay no more than 10% of your discretionary income toward your student loans. If you maintain good standing making these payments, you can expect the remaining balance of your student loans to be forgiven after 20 years.
In some cases, 10% of your disposable income will be less than the interest owed on your loans, so your loan balance will actually increase over time. That makes it very important to qualify for forgiveness, or you can end up worse off by using an IDR plan that doesn’t fit your financial future.
REPAYE (Revised Pay As You Earn)
Much like PAYE, in the REPAYE plan, you can generally expect to pay no more than 10% of your discretionary income toward your student loans. Your balance can then be forgiven after 20 or 25 years.
IBR (Income-Based Repayment)
The IBR plan is 10% of your discretionary income, just like PAYE, unless you borrowed before July 1, 2014, then it is 15%. Either way, your discretionary income determines how much you pay.
ICR (Income-Contingent Repayment)
The ICR plan is the highest amount at 20% of your discretionary income. How your percentage is calculated is also different, and we’ll discuss that later on in this article.
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Calculating Your Discretionary Income
With all of these percentages and contingencies, you’re probably wondering how to calculate your discretionary income. The most straightforward way is to take your disposable income and then minus all of your necessary expenses such as your mortgage or rent, utilities, and food.
Keep in mind that it is best, to be honest about what expenses are necessary. Netflix is not a utility, and eating out every day for lunch is not a necessary line item in your budget. Reviewing your budget every so often will give you a good idea of what your discretionary income is. But for student loans, that isn’t how to calculate it because there is too much subjectivity.
Instead, the Department of Education (DOE) has created a standardized way to calculate your discretionary income. They compare your Adjusted Gross Income (AGI) to the federal poverty level for your state and family size. Every dollar over 150% of the poverty line that you make is your discretionary income.
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For example, let’s say your AGI is $60,000, you live in California, and you have a family of 4. The poverty line for California for that family size is $36,900. 150% of $36,900 is $55,350 (36,900 X 1.5). That means your discretionary income would be $4,650 ($60,000 - $55,350).
This calculation may change slightly depending on the program you’re in. Please check your program’s specific guidelines. For example, the ICR plan only uses 100% of the poverty line and not 150%, which is a substantial difference in calculating your discretionary income.
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Rebalancing Your Discretionary Income
Every year you participate in an IDR plan, you must show proof that your income has not increased to maintain your low payments. But what if it has increased?
Since discretionary income is based on your AGI, you can increase or decrease your discretionary income in the eyes of your loan forgiveness program by changing your AGI. So if you are in the IDR plan for the long haul but suddenly have a pay increase, you could avoid increasing your payment on your IDR plan by reducing your AGI. For example, you could contribute more to a tax-advantaged retirement account to keep your AGI low.
Naturally, having more money coming in is not bad, but putting it into your future pocket instead of the government’s pocket is often in your best interests if you can afford to forego that income right now.
The Money Wrap-Up
Disposable income and discretionary income are two surprisingly nuanced terms. Understanding them and how they are calculated can help you to navigate your IDR plan. For example, you can change your discretionary income to suit your situation.
Knowledge is power, and being aware of this information as it pertains to your student loan payments can save you money down the road.