A lot of us budget month-to-month, which means we often spend a little extra one month and tell ourselves that we’ll make it up the next month. (Then the next month arrives and we tell ourselves we’ll make it up the month after that, and so on.)
Or we look at our monthly budget and ask ourselves whether we can afford next summer’s vacation, and when our budget tells us that we’ve already spent all of this month’s income we go ahead and book the vacation anyway because… hey, it will all work out, right?
If you want to know whether you can really afford that vacation (or that new pair of boots, or shampoo that isn’t designed for horses), you can’t look at a monthly budget. You have to look at your annual budget – and you need to know how much discretionary income you have for the entire year.
How to Calculate Your Annual Discretionary Income
Since all of us have slightly different income streams and expenses, we’ll all calculate our annual discretionary income in slightly different ways – but the basic formula is “income minus fixed/essential expenses.”
I'll use myself as an example.
I'm likely to earn around $86,000 in freelance income in 2018. From that number, I subtract:
- The 30% that goes to taxes ($25,848)
- The 15% that goes directly into my savings account ($12,924)
That leaves me with $47,387. Then I subtract my monthly overhead expenses:
- Rent ($849)
- Renters insurance ($21)
- Health insurance ($758 - and that's for a Bronze plan)
- Internet ($52)
- Phone ($128)
- Electricity ($33)
- Water ($33)
- Grocery store purchases, including food/toiletries/cleaning supplies/etc. ($300 - $400)
I have roughly $2,350 in overhead costs every month (before you ask, I don't have a car or any debt), so I multiply that by twelve and subtract it from $47,387.
That leaves me with $19,190 in discretionary income for the entire year.
Or $1,599 per month.
This income needs to cover all restaurant meals, movie tickets, haircuts, clothing, books, gifts, charitable donations, vacations, etc. etc. etc. If I want to spend less than I earn in 2018, I can't spend more than $19,190 on discretionary items - and since I'm a freelancer, my business spending has to come out of that $19,190 as well.
(Before you ask: yes, I know that putting more of my discretionary income towards my business is likely to reduce my taxes, which might give me a little more discretionary income that I can put towards personal expenses. If you want to dig down to that level on your own budget, go ahead.)
If you are a W2 employee, it might be more useful for you to calculate your discretionary income starting from your take-home pay, since taxes, retirement contributions, and healthcare deductions will already be taken out.
If you have variable income (freelancers, hourly workers, people with a bunch of side hustles) start with a conservative estimate. I'd love to earn more than $80,000 in 2018 - I'm always working towards increasing my freelance income - but it makes sense to budget as if that were all I might earn.
Likewise, once you know your discretionary spending number, you might want to keep your actual discretionary expenses below that number in case something happens to your income. But before you get to that step, you have to do one more thing.
Once You Have Your Annual Discretionary Number, Subtract Your Big Discretionary Expenses
This is how you know that you can for sure afford that vacation: you subtract it from your annual discretionary expenses for the year.
Same goes for holiday travel, gym memberships, even something as small as a Netflix subscription. If you can put a number on it and you know you are likely to spend it, subtract it.
In my case, I'm estimating that I'll have $19,190 in discretionary income for 2018. From past experiences, I know that Christmas will cost $1,600 and my annual vacation will cost around $800. That leaves me with $16,840, or $1,403 per month. From there, I can start pulling out recurring monthly costs:
- Netflix ($15)
- Haircut ($52)
- Patreon subscriptions ($78)
- Theatre tickets ($52)
That leaves me with $1,206 in discretionary income per month (which in my case needs to cover both business and personal expenses), and I haven't even factored in restaurants and clothing, which are two huge expenses for most people.
As you start calculating your annual discretionary income, you'll probably realise that you have much less spending money than you thought. That is the hard part of doing this exercise. The other hard part is sticking to your annual discretionary limit. You don't want to spend your entire discretionary budget by September!
However, sticking to - and staying below - your annual discretionary limit will make it easier for you to decide whether you can say yes to that weekend trip your friends are planning, as well as any other surprise opportunities (or expenses) that come your way in the next year.
And hey, if you do overspend, you can pay it out of the money you've been putting into your savings account every month. (You have been putting a little money into a savings account each month, right?)