Tax Credits and Income

This article explains the rules about what income to take into account when calculating Tax Credits, including what happens when a Tax Credit claimant makes a claim for Universal Credit.

This article was originally published on 6 March 2024. It was updated on 14 March 2024.

1. The Tax Credit income rules

What is included as income?

The types of income that are included are set out in The Tax Credits (Definition and Calculation of Income) Regulations 2002. For more information you can refer to Chapter 63 Part 3 of the Child Poverty Action Group Welfare Benefits and Tax Credits Handbook.

The amount of a client’s earned income taken into account is their gross taxable income. This is after deductions for pension contributions, but before any deductions for income tax or national insurance contributions.

For self-employed clients this will be their gross taxable profits.

For paid employment, any earnings from that employment are included, including wages, overtime pay, holiday pay, occupational sick pay, bonuses and taxable expenses. Note that the first £100 per week should be ignored of any Statutory Maternity Pay, Statutory Adoption Pay, Statutory Paternity Pay, Statutory Shared Parental Pay and Statutory Parental Bereavement Pay.

Other types of income taken into account include:

• taxable social security benefits, such as Carer’s Allowance, contribution-based Jobseeker’s Allowance and contribution-based Employment and Support Allowance
• miscellaneous taxable income such as copyright royalties
• Some student income — Adult Dependant’s Grant is taken into account but most student income is ignored
• Pension income, which includes personal and occupational pensions, state retirement pensions, and some benefits such as Widowed Parent’s Allowance
• Taxable income from savings and investments, such as interest on a savings account
• Rental income from a property held as an investment, unless exempt under the rent–a-room scheme. Rental income from a property business would be earned income from self-employment.
• Foreign income
• Notional income in some cases, for example if HMRC considers the client has deprived themselves of income in order to gain entitlement to TC.

The total of all the above types of income should be added together for the whole tax year. The first £300 from the sum of any pension, investment, rental, foreign and notional income in the tax year is ignored. In a joint claim, there’s only one £300 disregard from the total amount.

Which year’s income is taken into account?

Tax Credits (TC) are worked out for a tax year (6 April to the following 5 April). They are calculated based on the total income in the tax year the award relates to.

However, where income changes from one tax year to the next, a disregard of £2,500 is applied. Any increase or decrease of up to £2,500 from one tax year to the next is ignored entirely. In practice this means that the previous year’s income is used when there’s a change of less than £2,500. If the client’s income increases or decreases by more than £2,500 from one tax year to the next, the disregard is applied by taking the current year’s income and deducting or adding, respectively, £2,500.¹

Examples

• A client’s income is £12,000 in 2022/23 and is estimated to be £14,000 in 2023/24. As their income has increased by less than £2,500, the full increase is ignored when working out their TC award in 2023/24. The award will be calculated using the previous year’s income figure of £12,000.
• A client’s income is £7,500 in 2022/23 and £18,000 in 2023/24. As their income has increased by more than £2,500, their 2023/24 TC award will be calculated using the income figure of £15,500 (£18,000 minus the disregard of £2,500).
• A client’s income is £9,000 in 2022/23 and £8,000 in 2023/24. As their income has decreased by less than £2,500, the full decrease is ignored when working out their TC award in 2023/24. The award will be calculated using the previous year’s income figure of £9,000.
• A client’s income is £16,000 in 2022/23 and £3,000 in 2023/24. As their income has decreased by more than £2,500, their 2023/24 TC award will be calculated using the income figure of £5,500 (£3,000 plus the disregard of £2,500).

Calculating the TC award once you have the income figure

Once you’ve got the appropriate income figure, you can calculate the award of TC. The income figure is first compared to a threshold amount. If the client’s income is over the threshold, their maximum award will be reduced due to income. The threshold figures are set annually by the Government. The rate of the threshold depends on whether the client’s entitled to Child Tax Credit, Working Tax Credit or both. The rates are:

If the income is below the relevant threshold, no reduction is taken from the TC award.

If the client’s income is over the threshold, find the amount by which the income exceeds the threshold, then calculate 41% of this excess. This is the amount by which the maximum TC will be reduced due to income.

For example, if the income figure for 2024/25 is £10,000, the client is entitled to both Working Tax Credit and Child Tax Credit, and the TC award is being worked out for the whole tax year:

• The income figure is £10,000
• The threshold is £7,955
• The difference between these two figures is £2,045
• 41% of the difference is 838.45 — this is the amount that’s taken off the maximum TC award.

The annual income figure, the relevant threshold, and the maximum TC all need to be calculated over the ‘relevant period’ — the number of days that the TC award is being worked out for. To do this, you need to multiply the daily rates of the elements of the award by the number of days in the relevant period. For the income figure and the threshold, divide by the number of days in the whole tax year and then multiply by the number of days in the relevant period.²

For example, if the income figure for 2024/25 is £10,000, the client is entitled to both Working Tax Credit and Child Tax Credit, and the TC award is being worked out for a period of 200 days:

• The income figure for the relevant period is £5,479.45 (£10,000 / 365 x 200)
• The threshold amount for the relevant period is £4,358.91 (£7,955 / 365 x 200)
• The difference between these two figures is £1,120.54
• 41% of the difference is £459.42 — this is the amount that’s taken off the maximum TC award.

Provisional and final awards

To calculate a final TC award, you need to use the total income in the tax year of the TC award, compared to the previous tax year’s income. The problem of course is that it isn’t possible to confirm what the total income is for a tax year until after that tax year has ended. This means that the TC award can’t be finalised until after the end of the tax year that the award relates to.

Because of this, a provisional TC award needs to be calculated by HM Revenue and Customs (HMRC), to establish what award of TC someone is expected to have in that tax year. The provisional award will use an estimate of the current year’s income ( this is usually initially based on information held about the previous year’s income). The provisional award can be recalculated if the client contacts HMRC with additional information about what they expect to earn in that tax year.

At the end of the tax year, the TC award for that tax year will be finalised once the client has declared their actual income for that tax year. This involves calculating what their entitlement actually was now that their actual total income is known and can be compared to the income from the tax year before.

This can lead to an overpayment or underpayment if the actual income figure is different from the estimated figure originally used by HMRC. An overpayment will occur if the client earned more than expected and as a result, turns out to have been entitled to less TC than they actually got. An underpayment will occur if the client earned less than expected, so turns out to have actually been entitled to more TC.

Example — Celine

In 2022/23 Celine earned £16,000. When calculating the provisional 2023/24 TC award, HMRC assumes that she continues to have income of £16,000 in 2023/24. Celine does not give any information to HMRC during the 2023/24 tax year.

When the tax year ends, Celine declares that she actually earned £18,000 in 2023/24.

HMRC finalises the TC award. As Celine’s income has changed by less than £2,500 from one tax year to the next, the entire increase is disregarded. The finalised TC award uses an income figure of £16,000 — the same amount of income that was used in the provisional award. As a result, there is no underpayment or overpayment of TC.

Example — Maya

Maya has a maximum TC of £19,731.06 in 2023/24.

In 2022/23 Maya earned £14,500. When calculating her provisional 2023/24 TC award, HMRC assumes she has the same level of income in 2023/24. This gives her a provisional TC award for the 2023/24 tax year of £16,842.6 (around £323.89 pw)

At the start of June 2023, Maya gets a new better paid job. She estimates that her total earnings for 2023/24 will now be £24,000 (based on 2 months at her old job and 10 months in the new job). Maya contacts HMRC with this new estimate. HMRC uses a figure of £21,500 to calculate a new provisional TC award — as they disregard the first £2,500 of the increase from 2022/23. Maya’s provisional TC award for 2023/24 is recalculated as being £13,972.61 (around £268.70 per week).

The in-year adjustment means that Maya has already been overpaid in 2023/24. This is recovered by reducing her weekly payments for the rest of the year.

Maya works some additional shifts in the Christmas period, and continues working extra shifts in the new year to cover for a colleague. At the end of the tax year, when Maya completes her annual declaration it turns out she actually earned £28,000 in 2023/24.

HMRC now uses a figure of £25,500 to calculate Maya’s final TC award for 2023/24. This is £28,000 minus the disregard of £2,500. Maya’s final TC for the 2023/24 tax year is therefore recalculated as being £12,322.61 (around £236.97 per week).

As Maya was paid £13,972.61 TC in 2023/24 but was only entitled to £12,322.61, there’s an overpayment of £1,640 which will be recovered from Maya.

What information does the client need to give HMRC?

A client must give HMRC information about changes of circumstance that change their entitlement to the elements of TC, for example if there’s a change to the number of children they’re responsible for or the number of hours they work.

However, changes to their income are treated differently, as income is worked out annually, so these changes can only ever be confirmed after the tax year has ended. A client must declare their total income after the tax year ends, when renewing their TC, but does not need to report a change of income within a tax year (unless there’s been a formal request for information from HMRC).

If a client’s income changes, so that they expect to earn a different amount overall for that tax year, they can choose whether to:

• report this to HMRC so that their provisional TC are recalculated, or
• not report the change to HMRC, so that their TC continue to be calculated based on the previous estimated figure.

Example — Ian

Ian earns £24,000 in 2022/23. In August 2023, Ian’s hours are cut at work. As a result, Ian expects that he will end up earning around £20,000 in 2023/24.

Ian could contact HMRC with the estimate of £20,000. This will result in a small increase to the provisional TC award in 2023/24.

However, Ian decides to continue to have the TC calculated on the higher income. This way, if his income does end up being £20,000, he will be entitled to a lump sum underpayment once the TC award is finalised at the end of the tax year (this will be around £615). Ian feels that doing it this way will protect him from a possible overpayment that would occur if his TC are recalculated on the lower income but he then ends up increasing his hours again.

2. How these rules affect migration to UC

Finalising tax credits midway through a tax year after a claim for UC

When a client claims UC (including under managed migration), this terminates their TC award with effect from the day before the first day of the UC award.³ When this happens, a client’s TC need to be finalised for the part of the year up until the point the award terminates. The process for for working out their income is different in this situation.⁴ From 6 April 2024, the in-year finalisation process will apply to anyone with a migration notice who passes their deadline day — whether or not they make a claim for UC.⁵

Firstly, HMRC needs to calculate a ‘notional current year’s income’. This consists of any income that the client has actually received up until the date the TC award terminates. This is then divided by the number of days in this period. The figure is then multiplied by the total number of days in the tax year (365 in 2024/25) and rounded down to the nearest penny. This notional current year’s income is then subject to any disregard as normal. This is the income figure that’s then used to calculate the client’s entitlement for the part-year period of the award.

This can have a distorting effect especially if the UC claim is made early in the tax year. If the client has only received one or two sets of earnings so far, the amount of pay dates in comparison to days in the tax year before the UC claim can have a big impact on the TC entitlement. The situation was covered in a recent Upper Tribunal decision,⁶ which confirmed that the method set out in the legislation needs to be followed, even if this results in a higher or lower award of TC than would more accurately reflect the amount the client earns over the whole tax year.

Example — Maya

Maya’s maximum Tax Credits is £21,045.90 in 2024/25. Maya earned £28,000 in 2023/24 and expects to earn the same in 2024/25. Her provisional TC for 2024/25 is calculated as being £12,827.45 or £246.01 per week.

Maya is paid wages of £2,333.33 on 25 April 20243 and £2,333.33 on 25 May 2024. Her next pay is due on 25 June.

If Maya claims UC on 26 May, the income she’s earned so far in the part-year will be £4,666.66. This is divided over 50 days (the number of days in the tax year so far) and then multiplied by 365 to give a notional current year’s income of £34,066.61 This would be subject to the disregard as it’s higher than 2023/24 income, meaning that HMRC would use a figure of £31,566.61 — this is over £3,000 higher than what she actually expects to earn in 2024/25.

HMRC carries out the in-year finalisation based on this notional income figure. Maya’s TC is calculated as being £1,556.88 for the 50-day period. This is lower than the £1,722.07 she’s received from her provisional TC (7 weekly payments of £246.01), so there’s an overpayment of £165.19.

If instead Maya had claimed UC on 24 May, before receiving her May pay, the income she’d earned so far in the part-year would only have been £2,333.33. This would have been divided over 48 days instead of 50. After being multiplied by 365 this would give a notional current year’s income of £17,743.03. This would be subject to the disregard as it’s lower than 2023/24 income, meaning that HMRC would use a figure of £20,243.03. This is nearly £8,000 less than what Maya actually expects to earn in 2024/25.

In that situation, after the in-year finalisation the TC would have been calculated as being £2,105.15 for the 48 day period. If by this point Maya had received £1,722.07 TC (7 weekly payments of £246.01) there would be an underpayment of £383.08 owed to her, instead of an overpayment to be recovered.

The exact timing of the UC claim could therefore determine how the final TC award is calculated for the part of the year the client’s entitled to TC. This could lead to an overpayment or an underpayment. There could be some tactical advice about the exact timing of a UC claim for a TC claimant, whether under natural or managed migration, but this would need to be balanced against other factors such as whether a client is better off on UC, whether there’s anything they can do to maximise their transitional element, and whether there’s any deadlines approaching.

Calculating the transitional element: total legacy amount and indicative UC amount

When a client claims UC under managed migration, they will be entitled to a transitional element if their total legacy amount is higher than their indicative UC amount. This applies when a UC claim is made by someone with a migration notice, up to the final deadline. For more information about when a client qualifies for transitional protection, and explanations of the managed migration terminology, please refer to our Adviser Online article ‘A guide to managed migration’.

The amounts are calculated based on their circumstances on ‘migration day’, which is the day before the first day of the UC award. When their migration day is will depend on when the client claims UC.

• If they claim UC on or before their deadline day, their migration day will be the day before they claim UC
• If they claim UC after their deadline day but on or before their final deadline, their migration day will be the day before deadline day.⁷

For people entitled to TC, the total legacy amount includes a representative monthly rate of the TC that they’re entitled to. This is calculated by working out TC entitlement as if the migration day was a relevant period of one day. Their income will be calculated based on the information held by HMRC on that day.⁸ This will be whatever estimate of current year’s income is being used, subject to a disregard if this figure has changed compared to previous year’s income.

The indicative UC amount must also be calculated using the same amount of earned income that was taken into account in calculating the TC element of the total legacy amount.⁹ However, the way that the regulations are written indicates that the £2,500 disregard if income has changed shouldn’t be applied to the indicative UC amount. In practice this means that the figure used for the indicative UC amount will be whatever estimate of current year’s income is being used by HMRC, without the disregard being applied.¹⁰ This figure then needs to be converted into a monthly amount, and a notional amount of tax and NI contributions needs to be deducted. This is because TC uses gross earned income, but UC uses net earned income.

The amount of unearned income taken into account for the indicative UC amount should be the actual current amount of unearned income, rather than the unearned income figure used by HMRC.

Example — Lana and Rachel

Lana earned £22,000 in 2023/24 and expects to earn the same in 2024/25. Lana’s partner Rachel gets Carer’s Allowance, which came to a total of £3,991 in 2023/24, and is expected to be £4,258.80 in 2024/25 .This means that Lana and Rachel’s total income from both earnings and CA was £25,991 in 2023/24 and is expected to be £26,258.80 in 2024/25.

Lana and Rachel’s 2024/25 Tax Credits are calculated using the figure of £25,991 as the £2,500 disregard is applied to the change in the total income.

Lana and Rachel get a migration notice in July 2024 and claim UC on 15 August 2024.

The total legacy amount will be calculated using an income figure of £25,991 — the estimated current year’s income after the disregard has been applied.

The indicative UC amount will use an amount for Lana’s earned income based on the figure of £22,000 that was used by HMRC in calculating the TC. Converted into a monthly amount this would give £1,833.33. After notional tax and NICs are deducted, this could leave £1,613.44.

The indicative UC amount will also use an amount for unearned income, based on the unearned income that Rachel currently has. The monthly equivalent of the weekly CA rate in 2024/25 is £354.90.

A transitional element is calculated for Lana and Rachel using the figures set out above. The transitional element is added to the other elements of Lana and Rachel’s UC award.

The reduction due to income in each assessment period is based on the actual amount of earned and unearned income that Lana and Rachel have in that assessment period. For example, if Lana has net earnings of £1,800 in the first assessment period which runs from 15 August to 14 September 2024, the reduction due to earned income will be calculated based on these actual earnings. There will also be a reduction due to Rachel’s unearned income of £354.90. If the income in an assessment period is higher than the monthly earned income amount, derived from the HMRC figure, which was used for the indicative UC amount, there will be a higher reduction from the maximum UC in that assessment period. This will mean they actually get less in that month than they used to on Tax Credits, despite the inclusion of the transitional element. If their actual monthly income fluctuates, so will the UC award they get each month. This is not because of an impact on the transitional element amount, but just because of normal income deductions from the maximum Universal Credit.

Note that Lana and Rachel’s Tax Credits for the period 6 April 2024 to 14 August 2024 will need to be finalised. This will be done using a notional current year’s income figure based on the actual amount of Lana’s earnings in the period from 6 April to 14 August, subject to the disregard. Please refer to the example of Maya above for an explanation of how this is done.

Josh Gilbert is a Benefits Expert in the Expert Advice team at Citizens Advice.

The information in this article is correct as of the date of publication.

Unfortunately, we are unable to respond to comments left on the medium site — please contact expertadvicesupport@citizensadvice.org.uk if you wish to give feedback on an article.

References

[1] Section 7(3), The Tax Credits Act 2002; regulation 5, the Tax Credits (Income Thresholds and Determination of Rates) Regulations 2002

[2] The daily rate of each element of the maximum TC award is rounded up to the nearest penny, the income figure for the relevant period is rounded down to the nearest penny, and the amount of the threshold for the relevant period is rounded up to the nearest penny — regulation 7(3) of the Tax Credits (Income Thresholds and Determination of Rates) Regulations 2002

[3] Reg 8 of the UC (Transitional Provisions) Regulations 2014

[4] The procedure is set out in regulation 12A and Schedule 1 of the UC (Transitional Provisions) Regulations 2014. These make modifications to section 7 of the Tax Credits Act 2002 that change the legislation in cases where someone entitled to TC makes a claim for UC.

[5] Regulation 12A of the UC (Transitional Provisions) Regulations 2014 is amended by The Social Security and Universal Credit (Migration of Tax Credit Claimants and Miscellaneous Amendments) Regulations 2024, with effect from 6 April 2024

[6] HMRC v AS (TC): [2023] UKUT 67 (AAC)

[7] Regulations 46 and 49 of the Universal Credit (Transitional Provisions) Regulations 2014

[8] Regulation 53(2) of the Universal Credit (Transitional Provisions) Regulations 2014

[9] Regulation 54(2)(c)(i), The Universal Credit (Transitional Provision) Regulations 2014

[10] Under regulation 54(2)(c)(i) of the Universal Credit (Transitional Provisions) Regulations 2014, the earned income figure used for the indicative UC amount will be the earned income, as set out in regs (4) and (6) the Tax Credits (Definition and Calculation of Income) Regs 2002, that was used for the representative monthly rate of TC. This would then need to be converted to a monthly amount and a notional amount of tax and NI deducted. Although this is based on HMRC’s estimate of current year’s income, the other steps of how this is then used for the TC amount, including the £2,500 disregard, wouldn’t be relevant towards working out the indicative UC amount. While the earned income figure should come from the earned income taken into account under regs (4) and (6) the Tax Credits (Definition and Calculation of Income) Regs 2002, the disregard comes from a separate part of the Tax Credits legislation. The Tax Credits (Definition and Calculation of Income) Regs 2002 are made under section 7(8) of the Tax Credits Act 2002 whereas the provisions for the disregard come under section 7(3) of the Tax Credits Act instead. For working out the representative monthly rate of TC for the total legacy amount, the whole process in the TC legislation needs to be followed, whereas for the indicative UC amount only the part that sets out what’s counted as income is used from the TC legislation.