By Dr. Jim Dahle, WCI Founder
The term “discretionary income” gets thrown around all the time. However, it actually has a legal definition that does matter to many white coat investors, especially if they're still paying off student loans.
Definition of Discretionary Income
Discretion is defined by Merriam-Webster as individual choice or judgment. So, discretionary income is money that is left over, and you have to decide what to do with it. It is money that is not committed to anything else. It can be used for whatever you like. You can spend it, invest it, or give it away.
More information here:
Why Discretionary Income Is Great
I'm a big fan of discretionary income. I want your discretionary income to make up as much of your income as possible. Fifty percent, 80%, 90%, or even more. When you have very little of your income dedicated to fixed expenses, you can build wealth quickly. You can direct your money toward that which you value most. Perhaps most importantly, if something happens to your income, you can rapidly cut back on your variable spending and still be OK.
More information here:
Discretionary Income and Income Driven Repayment Programs
The federal student loan Income Driven Repayment (IDR) programs such as
- Income Contingent Repayment (ICR),
- Income Based Repayment (IBR),
- Pay As You Earn (PAYE), and
- Saving on a Valuable Education (SAVE), which used to be known as Revised Pay As You Earn (REPAYE)
all use the concept of “discretionary income” to determine your payments. The formula for discretionary income is really quite simple. According to the federal government, you take your income and subtract out 150% of the “poverty guideline.” In the case of SAVE, that percentage has increased to 225%. The amount left over is your discretionary income.
Your income for these purposes is defined as Adjusted Gross Income (AGI). That's your total income minus a few deductions like self-employed retirement accounts, self-employed health insurance, and HSA contributions.
The poverty guideline is published by the Department of Health and Human Services (HHS). It depends on where you live and on your family size. For 2023, the guidelines for those living in the Lower 48 can be found here.
So, let's calculate the discretionary income for a hypothetical resident. Let's say the resident is single and has an AGI of $60,000 per year. The poverty guideline is $14,580. So….
Discretionary Income = $60,000 – (1.5 × $14,580) = $38,130
This resident's classmate is married with two kids. What is the discretionary income there?
Discretionary Income = $60,000 – (1.5 × $30,000) = $15,000
These residents work with a married attending who has four kids. The attending makes $240,000, and their spouse makes $80,000. After a few deductions, their AGI is $300,000.
Discretionary Income = $300,000 – (1.5 × $40,280) = $239,580
Easy, peasy right? How does this play into the IDR programs? Well, each of the IDR programs requires you to spend a certain percentage of your discretionary income on your student loan payments as follows:
- ICR: 20%
- IBR: 15%
- PAYE: 10%
- SAVE: 10% (5% for undergraduate loans)
For the sake of simplicity, let's assume these three doctors are all enrolled in SAVE. What is their monthly payment?
- Single resident with a discretionary income of $38,130 pays $3,813 per year or $318 per month
- Married resident with a discretionary income of $15,000 pays $1,500 per year or $125 per month
- Attending with a discretionary income of $239,580 pays $23,958 per year or $1,997 per month
Let's take it one step further. Let's assume they all owe $200,000 of student loans at 6% (i.e., $1,000 per month of interest accumulating). The 10-year payment on this debt would be $27,174 per year or $2,264 per month. Thus, NONE of them are going to have this debt paid off in less than 10 years unless they make payments beyond what's required. In fact, that attending would have to pay $3,956 per month to get those loans paid off within the five years I recommend.
The REPAYE system used to offer a subsidy, where half of all unpaid interest was waived. That lowered the effective interest rate. With SAVE, though, no accrued interest will be added to your loan balance if you make your monthly payment. For example: if $500 in interest accumulates each month and you have a $200 payment, the remaining $300 would not be charged.
If you have student loans and will be in an IDR program, it is important to understand how your payments are calculated, what you can do to lower them further, and what you can do to increase your subsidies (under PAYE and IBR, the government will pay your interest for three years). As a general rule, the key to lowering payments and increasing subsidies is to lower your AGI. However, you can also decrease your discretionary income by adding family members (though beware that there are plenty of other costs if you take that route)!
Here are all the things you can do to lower your AGI, lower payments, and increase your subsidies:
- Get married to a non-earner
- Have children
- File a tax return with $0 in income as an MS4
- Contribute to tax-deferred retirement accounts and HSAs
- File taxes Married Filing Separately if married to a high earner (this works with PAYE and SAVE)
- Enroll in or change from ICR, IBR, or PAYE to SAVE
If you're having trouble sorting out exactly what to do in your situation, consider booking an appointment with StudentLoanAdvice.com. In exchange for an hour of your time and a few hundred dollars, you can be sure that you're doing the right thing with your student loans, tax filing status, and retirement accounts.
What do you think? What have you done to lower your discretionary income? How has that affected your student loan payments? Comment below!