Taxation on Tips and Overtime Earnings: What You Need to Know
Explore the impact of "Taxation on Tips and Overtime Earnings" for employers. Learn about changes, compliance, and reporting under new tax laws.
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NOVEMBER 2025
TABLE OF CONTENTS
TABLE OF CONTENTS
TABLE OF CONTENTS
TABLE OF CONTENTS
TABLE OF CONTENTS
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Description:
New laws. New thresholds. New risks. What employers need to know for 2026.
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The rules are changing again- and not just the numbers. Join Vida HR’s annual Compliance & Hot Topics session for a fast-moving look at what’s new, what’s coming, and what deserves your attention for 2026. You are not going to want to miss this important update!
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What’s changing with pay, benefits, and leave-and what’s not?
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Which 2026 updates carry hidden compliance risk?
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How do you prioritize policy, payroll, and communication changes now to stay ahead?
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We’ll unpack the latest federal and Colorado updates, share what’s quietly taking effect behind the scenes, and highlight where employers are most likely to get tripped up in the new year.
Taxation on Tips and Overtime Earnings
What You Need to Know
H.R. 1 2025, aka the One Big Beautiful Bill Act (OBBBA), was enacted on July 4, 2025, and includes a change on how overtime and tips are reported on Form W-2 for wages earned and reported in 2025 through 2028. This is a temporary provision of the OBBBA and, unless renewed through additional legislation, will expire at the end of 2028.
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When there is new legislation, especially when new legislation impacts taxes and takes effect retroactively, there are bound to be employee and employer questions and confusion.
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Let’s break down the changes based on the two categories: tip earnings and overtime earnings.
No Tax on Tips (Section 70201)
OBBBA allows employees to deduct up to $25,000 in qualified tips each year from their federal income withholding tax filing.
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Tip earnings above this threshold would be subject to federal income tax.
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All tip earnings are currently subject to state and local taxes – although individual state laws may vary, and some jurisdictions may choose to follow federal tax law.
Only employees in occupations that customarily and regularly* receive tips are eligible for claiming tip earnings as deductions on their taxes, based on occupations that met the criteria on or before December 31, 2024.
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*Customarily and regularly under U.S. Department of Labor (DOL) regulation means “a frequency which much be greater than occasional” and “may be less than constant.”
Tip earnings must meet specific requirements to qualify for deduction
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For tip earnings to qualify they must be voluntarily paid by customers in cash, by credit card, or other equivalent methods.
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Qualified tips must be received from customers voluntarily, including those received from a tip pool, but do not include service charges and mandatory gratuities.
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For example, if a restaurant charges an automatic gratuity on large parties, and the automatic gratuity cannot be waived or changed by the customer, these tips do not meet the definition of qualified tips for deduction purposes.
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All tips must be properly reported for the deduction to apply; in other words, tip earnings received “under the table” cannot be deducted on federal income taxes.
Occupation Eligibility
In September 2025, the Department of the Treasury and the Internal Revenue Service (IRS) published a proposed list of occupations that may qualify to claim tip earnings as deductions on their taxes. Common occupations that would qualify for the tip deduction might include bartenders, servers, ride-share drivers, hotel staff, hair stylists, among others. (Tipped-Occupations-Detailed-8-27-2025.pdf)
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Some jobs, including those in the Specified Service Trade or Business (SSTBs), are not eligible for the tip deduction. Common examples of SSTBs are healthcare workers, legal workers, performers, and athletes.
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The DOL has also published an opinion letter (FLSA2025-03) on September 30, 2025, to clarify the definition of eligible employees who “customarily and regularly” receive tips; this guidance is more narrow than the US Treasury definition, which was not mentioned in the DOL letter.
Under DOL guidance, to qualify as a tip-eligible employee, a worker must meet the following criteria:
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Work in view of customers.
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Engage with patrons and answer questions.
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Work in a role similar to positions historically recognized as tipped occupations.
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Employees who work in positions that do not have direct and regular contact with customers do not qualify as “tipped employees.”
No Tax on Overtime (Section 70202)
Non-exempt Employees are able to deduct up to $12,500 in FLSA-required overtime premium pay each year from their federal income withholding tax filing.
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Overtime earnings above this threshold would be subject to federal income tax.
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All overtime earnings are currently subject to state and local taxes – although individual state laws may vary and some jurisdictions may choose to follow federal tax law.
Employees who earn more than $150,000 (modified adjusted gross income) the tax deductions begin to phase out by $100 per additional $1000 earned.
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Based on the current understanding of the rules, individuals who file as Married Filing Separately would not be eligible to claim the deduction.
Some overtime wages will NOT qualify as deductible from federal income taxes, including the following:
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Overtime wages paid under state law overtime requirements, such as daily overtime requirements in states like California or Colorado.
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For example, in Colorado, if an employee works more than 12 hours in a workday or 12 consecutive hours, this qualifies as state-mandated overtime. This type of overtime is not eligible for the overtime tax deduction.
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Overtime wages paid in accordance with collective bargaining agreements that exceed FLSA requirements.
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Overtime premiums paid voluntarily by employers that are not required under the FLSA.
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Shift-differentials, weekend premiums, double-time, and any other non-FLSA overtime wages.
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Additionally, the overtime wages that can be deducted on employee taxes are ONLY the overtime premium amounts paid above the regular rate (difference between the overtime pay rate and regular rate). For example, an employee with a regular rate of $15.00 per hour and an overtime rate of $22.50 per hour would only be able to claim the $7.50 per hour premium portion of their overtime wages.
Employee and Employer Impact
Employees will not see an immediate impact on their paychecks – overtime and tips are not “tax-free”; no changes have been made to the FICA and income tax withholding rules for overtime and tips. Employees will continue to pay taxes on overtime and tip earnings through the year, and employers will continue to process applicable withholdings each pay period.
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What the law does change is that employers are required to track and separately report qualified FLSA-overtime premiums and tips on Form W-2. Employees will be able to provide the W-2 tax statement to their tax professional and claim a deduction when filing their taxes up to the limits allowed in the OBBBA for overtime and tip earnings.
Because the OBBBA was passed mid-year, there is confusion from employers on how to comply with the rule for wages already paid in 2025. The IRS has instructed employers to continue using the same process for reporting wages on the 2026 W-2 for the 2025 wages as the new legislation allows employers to use a “reasonable method” to estimate qualified overtime and tips, with exact reporting required for 2026 wages.
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The IRS is working on a revision to Form W-2 for 2026 wage reporting which will split Box 14 into 14a and 14b for tip reporting. Additionally, new codes for qualified overtime (TT) and qualified tips (TP) have been added. There is also a proposed draft W-4 for 2026 that would include additional instruction for employees on how to calculate their deductions to account for qualified tips and overtime.​
It is expected that the IRS will provide updated guidance for how employers and third-party payroll providers will be able to comply with the OBBBA provisions for 2025 wage reporting closer to the end of the year.
For Vida HR Clients
To ensure compliance with the tip and overtime premium earning reporting requirements on year-end tax statements, isolved is making system updates to reflect these amounts in Box 14.
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Overtime Premium Earnings will be reported as “Est OT Premium”
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Tip Earnings will be reported as “Tip Earnings”
isolved is also developing year-end reporting to show the tip and overtime premium amounts in the coming months.
Key Take Aways
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The OBBA does not eliminate tax on overtime and tip wages.
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Employees will be able to deduct qualifying tips and overtime earnings from their federal income tax filing each year, up to the specified thresholds, through 2028.
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The overtime and tip deduction is only applicable for federal income withholding taxes; FICA, state, and local taxes are unaffected.
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Not all overtime wages are eligible to be deducted – only the premium amount above the regular rate of pay qualifies for the deduction.
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Employee paychecks will not be impacted by overtime and tip deduction allowances – FICA, federal income, state income, and local income tax withholdings will still be processed each pay period by employers.
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In 2026, employees will have the option to change their Form W-4 withholdings to account for anticipated overtime and tip wages.
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Not all tips will be eligible to be deducted – only those tips earning by employees working in qualifying occupations will be deductible.
Additional Resources
QUESTION:
A manager at my company recently provided a reference check for a previous employee. That employee called our HR department to complain, saying the reference check was negative and cost him the job, and threatened to take legal action. Thankfully the situation is resolved, but now our company is scrambling to put a policy into place, so this doesn’t happen again.
What are the best practices for allowing reference checks and/or letters of recommendations for terminated employees?
Answer:
Reference checks and letters of recommendations, in regard to employment, are an increasingly outdated practice. While employment verification is a common practice, providing more personalized information about an employee’s performance at a specific company is not recommended. It can lead to potential complaints, even lawsuits, and doesn’t usually provide meaningful information to a prospective employer.
The only exception for this is if a previous employee requests a letter of recommendation for an educational institution, which does not have the same employment considerations.
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Long Answer
It’s important to delineate between a reference check, a letter of recommendation, and employment verification:​
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Employment verification is when an employer reaches out to a prospective employee’s former place of work, in order to confirm that employment information provided on an employee’s resume is accurate. This is a common practice, and it’s typical for employers only verify a former employee’s job title and dates of employment.
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Reference checks have a lot of crossover with employment verification, but with the added goal of evaluating a prospective employee’s performance at their previous job. This can be in the form of a survey, or a brief paragraph detailing an employee’s performance.
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Letters of recommendations are like reference checks, where a former employer or manager provides feedback on their previous employee's performance or character, but it is generally something the employee requests themselves in order to enhance their resume, not a requirement of the prospective employer.
Employment verification is best practice; limiting verification to dates of employment and job title only is best practice. This is to prevent bias, if an employer shares more information, especially if that information is performance related and potentially subjective, they run the risk of legal action. However, these risks are relatively low, as it’s not common practice to divulge such information when verifying employment.
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When a prospective employer or the former employee themselves reaches out for a letter of recommendation or reference, it is important that the information provided be factual and not based on opinion or be a result of retaliation or bias. Incorrect reference or employment verification information may result in a former employee losing out on a job opportunity or even go as far as legal action against the employer for defamation or wrongful termination.
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Best practice is for any verification of employment, reference check, or letter of recommendation be handled by HR and to stick to the bare minimum release of information. If your company allows managers to write a letter of recommendation for former or exiting employees, it is also important to ensure that it is clear that the letter is the manager’s opinion and not the stance of the employer.
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Now, there is one exception to this. Some colleges or other higher educations require a letter of recommendation. If you have an employee that is a student, and asks for a letter of recommendation, there is no issue in providing one, because it’s outside the realm of employment.
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EMPLOYEE HIGHLIGHT
EMPLOYEE HIGHLIGHT
EMPLOYEE HIGHLIGHT
Hello, I'm Barbara Campbell!
I was born in the coastal town of Port Maria, Jamaica, raised in Yosemite, Kentucky, and have called Colorado Springs home since 2001. My journey has shaped a deep appreciation for culture, learning, and connections, which have influenced how I approach life and my work in human resources today.
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With nearly a decade of experience in HR across healthcare, hospitality, and service industries. My career was launched with my first position as Human Resources Coordinator. Since then, I’ve had the privilege of growing through roles such as HR Generalist, HR Manager, Business Operations Manager, and now HR Business Partner II at Vida HR, where I’m dedicated to providing proactive, reliable HR support that helps organizations thrive and people succeed.
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In the Predictive Index, I’m categorized as a “Guardian” – a title that encapsulates my consistency for being detail-oriented and precise, with deep follow-through. Operating with a deep sense of responsibility to deliver quality, accurate, and compliant outcomes that align with each client’s unique needs.
​A little about me:
Outside of work, life is always an adventure with my son Jyden (19). Self-proclaimed foodies and avid explorers, with a passion for discovering new restaurants, local art, music scenes, athletic coaching, reading, spending time outdoors, audio-narration, and a thrill for learning new skills.
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I’m passionate about continuous growth both personally and professionally. Currently, I’m actively pursuing additional career and personal certifications and professional development opportunities to expand my expertise and enhance my ability to support the evolving needs of my clients and community. I also find great purpose in serving through several groups at my local church, where I help provide resources, encouragement, and empowerment to others.
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