Discretionary income: What it is and how it can affect student loan payments

More than $500 billion in federal student loan debt is being repaid under income-driven repayment (IDR) plans, according to the Government Accountability Office. If you're one of these borrowers, or hope to be soon, discretionary income plays a big part in determining your monthly payment amount.

The higher your discretionary income, the more the U.S. Department of Education assumes you can afford to pay each month toward your student loans. Learn what discretionary income is and more in this guide.

What is discretionary income?

In the context of income-driven repayment plans, discretionary income is the difference between your annual income and a certain amount of the poverty guideline defined by the federal government.

That amount depends on the type of IDR plan you're applying for:

• Saving on a Valuable Education (SAVE) Plan: Your discretionary income is the difference between your annual income and 225% of the poverty guideline for your family size and state.
• Income-Based Repayment (IBR) Plan and Pay As You Earn (PAYE) Plan: Your discretionary income is the difference between your annual income and 150% of the poverty guideline for your family size and state.
• Income-Contingent Repayment (ICR) Plan: Your discretionary income is the difference between your annual income and 100% of the poverty guideline for your family size and state.

The U.S. Department of Health and Human Services (HHS) publishes those poverty guideline figures each year.

The role of discretionary income in financial planning

Understanding your discretionary income can help you plan for student loan payments under an income-driven repayment plan.

Each year, you must update your income and family size with the U.S. Department of Education - a process called "recertifying" your IDR plan. If your income has increased, knowing your discretionary income helps you predict future changes.

For example, say you get a raise at work and want to use that additional income to save for a home or pay off credit debt. Understanding your discretionary income means you know that your student loan payment will increase the next time you have to recertify your loan, so you know you can't put 100% of your raise toward savings or credit card debt payments.

Discretionary vs. disposable income

Discretionary income sounds a lot like another personal finance term you might come across: disposable income. While they sound similar and both relate to income, they serve different purposes.

Disposable income is the amount of money you have left after paying taxes. It's what you might refer to as your "take-home pay," and you might use it for budgeting

For example, if your gross pay is $5,000 per month, but your employer withholds $1,000 for federal and state income taxes, payroll taxes, and other mandatory withholdings, then your disposable income is $4,000 per month. That's how much you have available to pay off debt and save for retirement, pay for necessities like housing, transportation, food, and utilities, and hopefully have some left over for wants like entertainment, travel, and shopping.

Discretionary income, on the other hand, is a specific calculation used to determine your student loan payment amount under an income-driven repayment plan.

The impact of discretionary income on student loan payments

By tying your monthly payments to your discretionary income, IDR plans help ensure monthly payments are affordable - even for borrowers with lower incomes. This prevents your loan payments from consuming a disproportionate amount of your budget.

Your monthly payments can increase or decrease as your income and family size fluctuate, ensuring your loan remains affordable even if your circumstances change.

After making 10 to 25 years of qualifying payments (depending on the plan), any remaining balance is forgiven under an IDR plan. So, your discretionary income can affect your monthly payments and the total amount you'll pay over the repayment period.

How to calculate your discretionary income

You don't have to calculate your discretionary income on your own - your loan servicer will handle it for you once you submit information on your income and family size. However, here's the process in case you want to get an idea of what your student loan payment will be.

The formula is:

Discretionary income = Adjusted Gross Income - (Factor x Federal Poverty Guideline for your family size and state)

Let's break down each of those inputs.

• Adjusted gross income (AGI): You can find this number on your most recently filed tax return. For example, in your 2023 Form 1040, it's on line 11.
• Factor: The factor depends on the type of IDR plan you're on. It might be 225%, 150%, or 100%. Divide that percentage amount by 100 for use in this formula (225% becomes 2.25, etc.).
• Federal poverty guideline for your family and state: The HHS's website has tables showing the poverty guidelines for the 48 contiguous states and the District of Columbia, Alaska, and Hawaii.

Once you have your discretionary income, you can estimate your monthly payment amount by dividing a percentage of your discretionary income by 12.

The percentage of your discretionary income used to determine your payment also depends on the type of IDR plan you're on.

Example of a discretionary income calculation

Here's an example of how that might work. Let's say you're single, live in California, are repaying your student loans on the SAVE plan, and your AGI is $75,000.

First, you look up the poverty guidelines for a single-person household in the contiguous United States in the HHS tables and find it's $15,060.

So, you would calculate your discretionary income as follows:

Discretionary income = $75,000 - (2.25 x $15,060) = $75,000 - $33,885 = $41,115

Next, you take 10% of your discretionary income: $41,115 x 0.10 = $4,111.50

Finally, divide that amount by 12 to find your maximum monthly payment amount under an IDR: $4,111.50 / 12 = $342.63

FAQ

What does 10% of discretionary income mean for student loans?

For federal student loans, discretionary income is the difference between your adjusted gross income and a certain percentage of the federal poverty guideline, based on your family size and state. That percentage depends on what type of income-driven repayment plan you use, and the federal poverty guideline amount is determined annually by the Department of Health and Human Services.

What does the IRS consider discretionary income?

The IRS doesn't specifically define "discretionary income." In the context of federal student loans, you calculate your discretionary income by subtracting a portion of the federal poverty guideline from your adjusted gross income.

The IRS defines adjusted gross income as total income minus any "adjustments to income" like contributions to retirement accounts, self-employed health insurance premiums, and student loan interest paid. You can find your adjusted gross income on your tax return.

Is a car payment considered discretionary income?

No, a car payment isn't considered discretionary income. Discretionary income is based on a formula the U.S. Department of Education uses to calculate your monthly federal student loan payments under an IDR plan. By setting your monthly student loan payments at a percentage of your discretionary income, the federal government ensures you have enough money left over to cover essentials like housing, car payments, and utilities.

Does a 401(k) count as discretionary income?

No, contributions to a 401(k) aren't the same as discretionary income. Your discretionary income is a portion of your adjusted gross income, which is your total income minus deductions, including contributions to a 401(k) account.