Tax Credits: Understanding the disregards
The disregards for income rises and falls are a unique feature of the tax credits system that cause a great deal of confusion amongst claimants.
The aim of this guide is to explain the disregards, how they operate, the problems they can cause and explain how they work with detailed examples.
- The income tests
- History of the income disregards
- Applying changes to the disregards
- Income rises
- Falls in income
- Income decreasing then increasing in-year
- Accrual of income during the year
- HMRC’s power to estimate current year income
The reason why overpayments are endemic in the tax credits system is that it works on the basis of pay now, establish entitlement later. Unlike other welfare benefits, entitlement to tax credits is fundamentally based on the tax year, 6 April to the following 5 April, and it is not until after the end of the tax year that entitlement for that year can be finally determined.
When someone claims Universal Credit in the same tax year and their tax credit claim ends mid-year, HMRC use a different in-year finalisation process which means the claim for that part of the year will be finalised fairly quickly without having to wait until after the end of the tax year.
In summary, the claim ‘cycle’ works like this:
- An initial award is made following receipt of the claim, based on the claimants’ current circumstances and income from the previous year.
- As the year progresses claimants can notify changes of circumstances. Certain changes must be reported whilst it is desirable to report others. Income changes do not need to be reported, but claimants can keep HMRC updated as to their estimated earnings for the current year.
- After the end of the year (or in-year finalisation), HMRC send the claimant(s) renewal papers, the purpose of which is to determine actual entitlement for the year just ended and, if appropriate, to act as a claim for the year ahead. HMRC do this by asking the claimant to confirm their income and circumstances for the year just ended.
TCA 2002, Section 7(1) states that entitlement to tax credits is dependent on the ‘relevant income’ not exceeding certain thresholds. This relevant income test does not apply to people in receipt of certain means-tested benefits (income support, income-based jobseeker’s allowance, income-related employment and support allowance and pension credit) who are therefore entitled to receive the maximum amount for their particular circumstances.
This means that each time HMRC calculate an award of tax credits, they must determine what income figure (the ‘relevant income’) to use in order to calculate entitlement. This normally requires a comparison between income for the current year and previous year.
TCA 2002, Section 7(3) goes on to explain how to determine relevant income. In summary this is:
For income rises – income disregard £2,500
(a) If current year income (CYI) is greater than previous year income (PYI) by no more than a certain amount (known as an income disregard, the final award is based on PYI;
(b) If CYI is greater than PYI by more than the specified income disregard, the final award is based on CYI less the income disregard, and an overpayment may arise.
For falls in income – income disregard £2,500
(c) If PYI exceeds CYI by no more than a certain amount (known as an income disregard) the final award is based on PYI;
(d) If PYI exceeds CYI by more than the specified income disregard, the final award is based on CYI plus that specified income disregard.
All other cases
Where none of the above apply, the claim is based on CYI. In this context, CYI means income for the year for which the award is being calculated whilst PYI refers to income for the year before. For example, when calculating an award for 2022/23, 2022/23 will be the current year and 2021/22 the previous year.
The income disregard, for rises in income, from 2003-04 to 2005-06 inclusive was £2,500. Its purpose was to provide a ‘buffer zone’ in which a family’s income could increase during the course of a year without affecting their tax credit entitlement. Though considered generous at the time it was introduced, the £2,500 buffer zone proved insufficient to prevent hardship to families whose income increased above that amount. Therefore in 2006-07, in a bid to reduce the volume of overpayments arising from increases in income, the income disregard was increased quite dramatically to £25,000.
That was probably the most significant of the changes announced in the Pre-Budget Report on 5 December 2005, and the overpayment figures relating to the 2006-2007 tax year showed a significant fall in both the number and amount of overpayments. HMRC have attributed this largely to the increased income disregard.
The effect of the increase was to bring greater certainty for claimants in a system where a major problem had been the sheer unpredictability of what families could expect to receive. The June 2010 Emergency Budget announced further changes to the disregard both by introducing a disregard for falls in income of £2,500 from April 2012, but also by reducing the disregard for increases in income from £25,000 to £10,000 from April 2011. This was further reduced to £5,000 from April 2013, and from April 2016, the disregard for increases in income is back to the original figure of £2,500.
The disregard for income rises has changed more than once since the tax credits system began and HMRC introduced a disregard for falls in income from April 2012. There is sometimes confusion about when newly announced disregards should be applied.
In simple terms, a new disregard applies to the calculation of all claims for the year it was introduced and later years.
Similarly, the £2,500 disregard (implemented from 6 April 2016) applies only to income rises in 2016-2017 and later years. The £2,500 disregard for falls in income applies only to 2012-2013 and later years.
Sanjay receives his renewal papers for the 2015-2016 tax year in May 2016. When finalising the 2015-2016 tax year, HMRC compare CYI (2015-2016) against PYI (2014-2015). The £5,000 disregard is applied to any income rises between the two years. This is because the claim being calculated was 2015-2016 and the decrease in disregard did not occur until 6 April 2016 (2016-2017).
Sanjay’s initial award for 2016-2017 would have been based on income from 2015-2016. Any re-calculation of his 2016-2017 award, including when HMRC finalised it, will have been done by comparing his 2016-2017 income (or estimated income if before finalisation) against his 2015-2016 income. The £2,500 disregard would be applied during the comparison.
When Sanjay received his renewal papers for the 2016-17 tax year in May 2017, HMRC will have compared CYI (2016/17) against PYI (2015/16). The £2,500 disregard will be applied to any income rises between the two years because the £2,500 level of disregard applies in 2016-2017 and later years.
Operation of the disregard for income rises between current year and previous year
Each time HMRC calculate tax credit entitlement (other than for initial awards at the start of the year) it normally requires a comparison between income for the current year and previous year.
Two of the income tests are relevant to rises in income. For 2022/23 awards:
- If CYI is higher than PYI by £2,500 or less, the award will be calculated using PYI.
- If CYI is higher than PYI by more than £2,500, the award will be calculated using CYI minus £2,500.
The effect of this is to create a disregard for rises in income from one year to the next up to a certain value, so that claimants will not necessarily face an immediate reduction in their tax credits should they start a higher paid job or increase their income in some other way.
Jason claims tax credits on 6 April 2023. His initial award is based on previous year self-employed income of £10,000. In October 2023, Jason gets a second job and his income for 2023/24 is actually £12,000. When HMRC finalise Jason’s 2023/24 award, they will use an income figure of £10,000 because Jason’s CYI is higher than PYI but by less than £2,500.
Note that in 2024/25 Jason’s claim will be based on his actual 2023/24 income of £12,000 (which at that point has now become his PYI) and so Jason’s increase in income will reduce his tax credits for the following year (2024/25).
Sanjita claims tax credits on 6 April 2023. Her initial award is based on PYI self-employed income of £10,000. Soon after claiming, she gets a new job with an increased salary. Her 2023/24 income is actually £18,000. When HMRC finalise Sanjita’s 2023/24 award they will use an income figure of £15,500 (£18,000 minus £2,500) because her CYI is higher than PYI by more than £2,500.
Importance of reporting income rises
It might at first seem that any income rises of £2,500 or less, because they have no effect on the current year’s award, need not be reported to HMRC until the renewal process gets underway at the start of the following tax year. But in fact it is sound advice to report such changes during the current tax year, even if they have no effect on the current year’s entitlement, in order to avoid overpayment of provisional payments in the early part of the following tax year.
Indeed, HMRC check the CY earnings information on the tax credit claim with the earnings information from RTI data provided by employers and pension providers for tax purposes (see section on RTI and tax credits) to help avoid overpayments. It is also important to bear in mind the impact of CY income on overpayment recovery rates. You can read more about recovery of overpayments from ongoing awards in our section on Dealing with overpayment debt.
Jason, from example 1, had two choices when he started his second job. By waiting until renewal time to tell HMRC of his rise in income, his 2023/24 award would be unaffected (because the rise in income was less than £2,500). However his 2024/25 award would be based for the first part of the year on an income of £10,000 until HMRC found out the correct income of £12,000. This would mean Jason is overpaid for the first few months of 2024/25.
By telling HMRC of his rise in income when it happens, HMRC can use the £12,000 figure from April 2024 when they start provisional payments ensuring that his 2024/25 award is paid using the most up to date information.
As well as encouraging people to update income figures before the end of the year, HMRC have introduced other measures to guard against overpayments generated by provisional payments that reflect outdated income figures. Where claimants have not provided up-to-date information about their income and circumstances, the income figure used to calculate provisional payments has been up-rated by the average percentage increase in earnings.
The final two income tests in TCA 2002, Section 7 apply to falls in income from one year to the next. Prior to the 2012-2013 tax year, HMRC did not apply this disregard.
Falls in income prior to 2012-2013
Claimants who thought their income might be lower in the current year were able to contact HMRC with an estimated current year income and have their award re-calculated based on that estimate. This generally meant tax credits would increase.
Ferdinand and Miranda had a joint income of £27,000 in 2010/11 (£13,500 each). Ferdinand lost his job and the couple estimated that their 2011/12 income would only be £16,500. They reported this estimated income to HMRC on 1 July 2011, and their tax credits were adjusted accordingly.
From 6 April to 30 June, Ferdinand and Miranda were paid tax credits based on a joint income of £27,000 (their 2010/2011 income). From 1 July 2011 to 5 April 2012 Ferdinand and Miranda received tax credits based on an income of £16,500 (based on Miranda working for the entire year at a salary of £13,500, and Ferdinand being paid (say) £3,000 for the early part of the year in which he was still in work.) Their tax credits increased from 1 July 2011 due to the estimated fall in their income.
An alternative option open to claimants in this position was to wait until the end of the tax year, allowing their award to continue based on previous year income, and declare their actual lower income for the current year at renewal time. This would result in an underpayment and the claimant receiving a lump sum of arrears after the end of the tax year because their claim would be reassessed using their lower current year income. When deciding whether to opt for a lump sum or an immediate increase in weekly claimants, the impact on means-tested benefits, such as housing benefit and council tax benefit could be considered.
If Ferdinand and Miranda had chosen to wait until renewal time to tell HMRC their income for 2011/12 was £16,500, they would have received a lump sum payment of £4305 (£27,000-£16,500 x 41%)
Falls in income in 2012-2013 and later years
Since 6 April 2012, HMRC apply an income disregard for falls in income as well as rises. The power to do this has always existed in TCA 2002, Section 7, but until 2012 HMRC chose not to use it. This disregard is applied to the calculation of any award for 2012-2013 and later years.
The income tests as they apply to falls in income are:
- If CYI is lower than PYI by £2,500 or less, the award will be calculated using PYI.
- If CYI is lower than PYI by more than £2,500, the award will be calculated using CYI plus £2,500.
The disregard simply means that awards are not adjusted until current year income falls by more than £2,500 when compared to previous year income.
If Ferdinand and Miranda’s situation from Example 4 arose in 2023/24 we would see a different outcome. Their initial award would still be based on income from the previous year (2022/23) of £27,000. However, when the couple contact HMRC with their estimated current year income of £16,500, HMRC will no longer revise their current claim based on that figure.
Instead it will be based on £16,500+£2,500 (the income disregard), i.e. an income of £19,000. Providing that their estimated income (£16,500) turned out to be correct, their 2023/24 award would be finalised on this amount as wel
The following examples show further how this disregard works in practice.
Annie, a lone parent, is paid £12,000 a year, but loses her job in July 2023. She contacts HMRC, and re-estimates her 2023/24 income to be £3,000. Her revised award will be calculated as though her estimated income were £5,500, because the first £2,500 of the fall in her income will be disregarded.
Whilst this is a relatively simple concept where someone only has one fall in income, it can become more complicated as the following examples illustrate:
Jeremy has an income of £15,000 in 2022/23. His initial award for 2023/24 is based on £15,000 (previous year income). Jeremy’s work hours are reduced and he believes his income will only be £10,000 for 2023/24. He contacts HMRC, who revise his award to be based on £12,500 (not the actual £10,000 estimate) due to the £2,500 income disregard.
Jeremy’s hours are further reduced, so that by Christmas 2023 he anticipates his income for 2023/24 will be £8,000. He contacts HMRC again and they revise his award to be based on £10,500 (His estimated income of £8,000 plus the £2,500 disregard).
When Jeremy finalises his 2023/24 award, his actual income turns out to be £13,000. His 2023/24 award will be finalised using an income of £15,000.
This is because the award is finalised by comparing CYI to that of the previous year. His CYI (2023/24) is £13,000 and his PYI was £15,000. Although his current year income is less than previous year income, it has not fallen by more than £2,500 and so his award is finalised on previous year income.
In earlier years, Jeremy’s claim would have been finalised on the CYI figure of £13,000. Jeremy will also have an overpayment as the estimates he gave during the year turned out to be too low.
The situation becomes more complex when the income disregard for falls in income is coupled with the disregard for rises in income over a three year period.
Peter has an actual income of:
In this situation, Peter’s 2022/23 award would be finalised using an income figure of £12,500 because the first £2,500 of the fall between PY (2021/22) and CY (2022/23) is disregarded.
His 2023/24 award would be finalised on an income of £10,000 because CYI (2023/24) has increased when compared to actual PYI (2022/23), but by less than £2,500 (the disregard for income rises from April 2016). One important point to note when looking at the 2023/24 award, 2022/23 is the previous year and it is the actual income figure for that year (£10,000) rather than the ‘deemed’ income figure of £12,500 actually used in 2023/24.
In summary the figures below show Peter’s actual income for each year along with the income used to finalise his tax credits award for that year.
2022/23: £10,000 | £12,500
2023/24: £12,000 | £10,000
The interactions of both income disregards over several years means that income for tax credits purposes rarely reflects the actual income for any given year.
In Example 8, we noted that there is a particular issue where income falls and the claimant gives an estimate but that estimate turns out to be too low because their income has increased again in the same year. Where this happens, substantial overpayments can be created.
It is for this reason that when claimants estimate that their current year income will be lower than previous year, they should take care to ensure that the estimate is not too low. As explained above (example 5), one way of ensuring this does not happen is to wait until actual current year income is known before reporting it to HMRC i.e. after the end of the tax year. This will mean the claimant receives an underpayment. There may also be other advantages in relation to means-tested benefits such as housing benefit and council tax benefit by taking a lump sum rather than an immediate increase in weekly payments.
IMPORTANT NOTE: The advice given above regarding reporting a fall in income is based on our interpretation of the legislation. In particular, the decision on whether to report an income change in part relies on the fact that if reported at renewal time, any underpayment will be paid to the claimant immediately as required by Section 30 Tax Credits Act 2002. However, the HMRC manual suggests that in practice HMRC may use any such underpayment and offset it against any ‘notional’ overpayment that has occurred in provisional payments of the new tax year. If this happens, the claimant should immediately contact HMRC and ask for the underpayment to be paid to them in full and if this is refused should lodge an appeal against the final award for the year just ended at the same time filing a complaint.
In reality, most claimants who have a fall in income need the increased tax credits as soon as possible.
Since April 2012, any falls in income of less than £2,500 means the current year award is not revised as outlined in the first section. Prior to that date, any fall in income would result in a re-calculation if the estimate was given to HMRC.
Prior to the 2007-2008 tax year, where someone reported a lower CYI estimate to HMRC, they would amend the tax credit claim and pay a lump sum for the underpayment that had accrued between 6 April and the date the award was amended.
The problem with this approach was that if the estimate turned out to be too low, an overpayment up to the value of the lump sum plus the new rate of payments was created. This problem was partly alleviated by a measure introduced in 2007-2008 and which continues today.
HMRC will still continue to amend claimant’s awards where a lower CYI estimate is given, but they will only amend the on-going payments. Any underpayment that has accrued up until that point will be held back and noted as a ‘potential payment’ on the claimant’s award notice. If the estimate turns out to be correct, the potential payment becomes an underpayment and will be paid to the claimant shortly after their claim for the year is finalised.
If the estimate turns out to be too low, the ‘potential payment’ will be used to reduce any overpayment.
Revisiting Ferdinand and Miranda from Example 6: when Ferdinand and Miranda estimated their CYI as £16,500 (a fall from their PYI of £27,000), HMRC would base their final award on an income of £19,000 (being the new estimate + the £2,500 disregard). As a result payments would be altered and increased from 1 July 2023 to 5 Apr 2024.
However, for the period from 6 April to 30 June 2023, Ferdinand and Miranda will have been paid tax credits on an income of £27,000, when in fact they should have been paid on an income of £19,000. This means they have been underpaid for a 3 month period. HMRC will hold back the amount for these 3 months as a potential payment which will be paid as a lump sum after the end of the year providing the couple’s estimate of their income for 2023/24 proved to be correct (i.e. was £16,500).
If Ferdinand and Miranda’s estimate of £16,500 turned out to be incorrect and their actual income for 2023/24 was £20,000, their 2023/24 award would be finalised using an income of £22,500 (their actual income plus the £2,500 disregard).
This means that between 1 July 2023 and 5 April 2024, the couple are overpaid because payments were based on an income of £19,000 when it should have been £22,500. However, during the period 6 April 2023 to 30 June 2023, the couple received tax credits on an income of £27,000 which was too high and a potential payment had accrued for that period. Although the potential payment will be reduced, because their income only fell to £22,500 rather than £19,000, the remainder of it will be offset against the overpayment in the second half of the year. As a result there will either be an overall underpayment for 2023/24 (if the remaining potential payment is higher than the overpayment accruing between 1 July 2023 and 5 April 2024) or an overpayment (if the remaining potential payment is lower than the overpayment that occurred between 1 July 2023 and 5 April 2024).
It should be noted that although we talk about in-year under and over payments, by law underpayments and overpayments don’t exist until the year is finalised. We simply use these terms to explain how awards are calculated and re-calculated throughout the year as income changes.
Accrual of income during the year
One of the features of the annual basis of assessment for tax credits is that income, as assessed for tax credits purposes, is deemed to accrue evenly day by day throughout the year. Therefore, in tax years when the income disregard for increases in income is only £2,500, claimants reporting such an increase will notice that an overpayment has accrued for the period before they reported the increase, as well as after, even if they reported the increase promptly. A simplified example will illustrate how this works.
Fergus and Deirdre made a joint claim for tax credits in 2023/24. In the first six months of 2023/24, only Fergus is working. Their joint income for 2022/23 was £12,000 a year, Fergus’s annual salary. Therefore, for the first six months of 2023/24 their tax credit award is based on a joint income of £6,000 (half a year of Fergus’s earnings). Fergus continues on the same salary level in 2023/24. Halfway through the tax year Deirdre starts working, also earning £12,000 a year, so their joint income for the second half of the year increases to £12,000. Fergus and Deirdre report this change to HMRC straight away, who process it promptly. HMRC re-calculate their tax credits accordingly ignoring the first £2,500 of the income increase.
Because of the way the regulations spread income over the whole tax year, when Fergus’s and Deirdre’s income for the whole of 2023/24 is re-calculated, it is spread evenly over both six-month periods. Thus, because their annual income is now £18,000 (£12,000 for Fergus and £6,000 for Deirdre), their joint income for the first six months is deemed to be £9,000, not £6,000. Even with the £2,500 disregard, this is bound to make a difference to their entitlement for those six months and could mean that an overpayment will have arisen in that period.
This ‘washback’ effect of income-based overpayments was hardly noticeable when the disregard increased to £25,000 but the problem re-appeared as the disregard fell back to £10,000 (from April 2011) and then further to £5,000 (from April 2013) and again to £2,500 (April 2016). But in earlier years, the fact that overpayments could arise even if claimants reported everything promptly, and did all that they were supposed to do, was barely acknowledged in HMRC literature and guidance. Hence, a lack of claimant understanding – not helped by incomplete or misleading guidance from HMRC – merely compounded the problem of overpayments in the early years.
TCA 2002, Section 7(10) states that:
‘The Board may estimate the amount of the income of a person, or the aggregate income of persons, for any tax year for the purpose of making, amending or terminating an award of a tax credit; but such an estimate does not affect the rate at which he is, or they are, entitled to the tax credit for that or any other tax year.’
This allows HMRC to estimate a person’s CYI, but they cannot do so when finalising entitlement for that year. In the early years of the tax credits system, HMRC did not use this power; however, they have started to use it in specific compliance-related circumstances, such as where a self-employed person returns an estimated income by 31 July and does not contact HMRC with their actual income by the following 31 January.
HMRC must by law finalise the award for the year just ended using the estimated figure as an actual. However, as the claimant has not made contact, if HMRC cannot confirm their estimate using information from the claimant’s self-assessment returns, they will estimate a very high income figure on the current year award which consequently reduces payments to Nil. The aim of this is to prompt contact by the claimant. However, they cannot use their very high estimate to finalise the current year claim and so must obtain the actual amount from the claimant or revert to the previous estimate given by the claimant at the point of finalisation. It remains unclear whether HMRC continue to use this power or extend its use to other areas.
Last reviewed/updated 4 May 2023