Taxation on Tips and Overtime Earnings: What You Need to Know
- Debra Fowler, SHRM-CP
- Oct 29
- 6 min read
Updated: Oct 30
Taxation on Tips and Overtime Earnings: What You Need to Know
By: Debra Fowler , SHRM-CP | Director, HCM Solutions
H.R. 1 2025, aka the One Big Beautiful Bill Act (OBBB), 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 OBBB and, unless renewed through additional legislation, will expire at the end of 2028.
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.
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.
Tip earnings above this threshold would be subject to federal income tax.
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.
*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:
For tip earnings to qualify they must be voluntarily paid by customers in cash, by credit card, or other equivalent methods.
Qualified tips must be received from customers voluntarily, including those received from a tip pool, but do not include service charges and mandatory gratuities.
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.
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)
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.
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:
Work in view of customers.
Engage with patrons and answer questions.
Work in a role similar to positions historically recognized as tipped occupations.
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.
Overtime earnings above this threshold would be subject to federal income tax.
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.
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:
Overtime wages paid under state law overtime requirements, such as daily overtime requirements in states like California or Colorado.
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.
Overtime wages paid in accordance with collective bargaining agreements that exceed FLSA requirements.
Overtime premiums paid voluntarily by employers that are not required under the FLSA.
Shift-differentials, weekend premiums, double-time, and any other non-FLSA overtime wages.
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.
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.
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.
Overtime Premium Earnings will be reported as “Est OT Premium”
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
The OBBA does not eliminate tax on overtime and tip wages.
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.
The overtime and tip deduction is only applicable for federal income withholding taxes; FICA, state, and local taxes are unaffected.
Not all overtime wages are eligible to be deducted – only the premium amount above the regular rate of pay qualifies for the deduction.
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.
In 2026, employees will have the option to change their Form W-4 withholdings to account for anticipated overtime and tip wages.
Not all tips will be eligible to be deducted – only those tips earning by employees working in qualifying occupations will be deductible.
Additional Resources:
Taxation on Tips and Overtime Earnings: What You Need to Know
Comments