Buzz
A lot of us manage our finances on a month-to-month basis, often overspending in one month and promising ourselves that we'll make up for it next month. (Then, the following month arrives, and we convince ourselves that we'll balance it out the next month... and so on.)
Or we glance at our monthly budget and wonder if we can afford next summer’s vacation. When the budget reveals we've already spent all of this month’s earnings, we go ahead and book the trip anyway because... hey, it’ll work out, right?
If you want to know if you can truly afford that vacation (or those new boots, or shampoo not meant for horses), you can't rely on a monthly budget. You must consider your annual budget—and understand how much discretionary income you have for the full year.
How to Calculate Your Total Annual Discretionary Income
Since each of us has unique income sources and expenses, we all calculate our annual discretionary income a bit differently—but the fundamental formula remains “income minus fixed/essential expenses.”
Let me use my own situation as an illustration.
I expect to earn roughly $66,000 from freelance work in 2018. From that total, I deduct:
30% for taxes ($19,800)
15% into my savings account ($9,900)
This leaves me with $36,300. From there, I subtract my monthly fixed expenses:
Rent ($650)
Renters insurance ($16)
Health insurance ($580.60—for a Bronze plan)
Internet ($40)
Phone ($98)
Electricity (~$25)
Water (~$25)
Grocery purchases, including food, toiletries, cleaning supplies, etc. ($300-400)
My monthly overhead costs total around $1,800 (and no, I don’t have a car or any debt). I multiply that by twelve and subtract it from the $36,300.
This leaves me with $14,700 in discretionary income for the entire year.
Or $1,225 each month.
This money needs to cover all non-essential spending: dining out, movie tickets, haircuts, clothing, books, gifts, charitable donations, vacations, and more. If I want to spend less than I earn in 2018, I can’t exceed $14,700 on discretionary items—and since I’m a freelancer, my business expenses come out of that $14K as well. (And yes, I know that directing more of my discretionary income towards my business could lower my taxes, which might give me more discretionary funds for personal expenses. If you want to explore this deeper for your own budget, feel free to do so.)
If you're a W2 employee, it might be more helpful to calculate your discretionary income based on your take-home pay, since taxes, retirement contributions, and healthcare deductions will already be deducted.
For those with variable income (freelancers, hourly workers, people with multiple side gigs), start by using a conservative estimate. I’d love to earn more than $66K in 2018—I'm always working to grow my freelance income—but it makes sense to budget as if that were all I might make.
Similarly, once you know your discretionary spending limit, you may want to keep your actual discretionary expenses below that limit in case your income fluctuates. But before moving on to that step, there’s one more thing to do.
Once You Have Your Annual Discretionary Income, Subtract Your Major Discretionary Expenses
This is how you can be certain you can afford that vacation: subtract it from your total annual discretionary expenses for the year.
The same applies to holiday travel, gym memberships, or even something as simple as a Netflix subscription. If you can assign a number to it and anticipate that you'll spend it, subtract it.
For me, I’m estimating $14,700 in discretionary income for 2018. Based on past experience, I know Christmas will cost around $1,200, and my yearly vacation will be about $600. That leaves me with $12,900, or $1,075 per month. From there, I can begin deducting recurring monthly expenses:
Netflix ($11)
Haircut ($40)
Patreon subscriptions ($60)
Theater tickets ($40)
That leaves me with $924 in monthly discretionary income (which, in my case, must cover both business and personal costs), and I haven't even accounted for dining out or clothing—two major expenses for most people.
As you work out your annual discretionary income, you’ll likely find that you have much less spending money than you expected. That’s the tough part of this exercise. The other challenge is sticking to your annual discretionary budget. You don’t want to blow through your entire discretionary allowance by September!
However, sticking to—and remaining under—your annual discretionary budget will help you decide whether you can accept that weekend getaway your friends are planning, or any other unexpected opportunities (or costs) that come your way throughout the year.
And if you do end up overspending, you can cover it with the money you’ve been setting aside in your savings account each month. (You have been saving a little each month, right?)
