No tax on tips and overtime: Communicating the new deduction to employees

One of the most talked-about elements of the recently passed One Big Beautiful Bill Act (OBBBA) is the “no tax on tips and overtime” rule. While the name is attention grabbing, it can also lead to misconceptions. 

Employees may qualify for new federal income tax deductions on tips and overtime wages. However, those earnings are still fully taxed through payroll. Employers need to understand this distinction and communicate it clearly to avoid confusion, especially in high-turnover, service-driven industries.

The reality behind “no tax on tips”
Staff will still see tax withheld from tips on their paychecks. What’s changed is that they may now claim a deduction of up to $25,000 per year for qualified tips on their federal income tax return. But not all tips count.

To qualify, the tips must be:

• Cash or credit card tips, as opposed to non-cash gifts like tickets.
• Voluntarily given by the customer, not automatic service or gratuity charges.
• Earned in a tipped occupation, as defined by the Fair Labor Standards Act (FLSA). A list of eligible occupations is expected from the IRS by October 2, 2025. 

Importantly, the deduction only applies if the employee includes their Social Security number on the tax return and, if filing jointly, their spouse’s as well. The benefit phases out for individual incomes over $150,000 or joint filers earning more than $300,000.

What this means for employers
There’s no change to payroll obligations, as employers must still withhold taxes on all tips. However, they have a critical role in helping their staff understand how the deduction works. Misinformation can lead to frustration when they see no change in their take-home pay.

Recommended steps:

• Provide tip-earning staff with a plain-language FAQ.
• Clarify that the deduction takes effect only when filing their annual tax return, not in each paycheck.
• Encourage employees to consult with a tax advisor before adjusting their withholdings on the W-4 form.

The facts about overtime deductions
Similarly, the legislation allows employees to deduct up to $12,500 in qualified overtime pay for individuals and $25,000 for joint filers. However, this only applies to the premium portion – the federally mandated “time and a half” part – of their overtime earnings.

For example, if someone earns $10 per hour, with no other compensation such as bonuses or shift differentials, their overtime rate is $15 per hour. Only the $5 per hour premium is eligible for the deduction. Like tips, overtime pay is still fully taxed through payroll and reported on Form W-2.

This deduction doesn't apply to overtime pay that workers receive solely due to state laws that mandate overtime for fewer hours than the 40-hour workweek threshold set by the FLSA.

Similar to the tip rule, it is subject to phase-out rules for taxpayers exceeding $150,000 in individual income and $300,000 for joint income. Employees also must include their social security number when filing.

What employers should do
Employers may not need to change how they process or report overtime wages, but they should be prepared to:

• Separate federal from state overtime in their timekeeping systems, or work with their payroll provider to do so.
• Educate on what “qualified” overtime means.
• Reinforce that deductions apply at personal tax filing time, not paycheck to paycheck.

Once guidance is published by the IRS, consider scheduling a short training or sharing a one-pager with overtime-eligible staff that explains how the deduction works and if there are any employee-related responsibilities within the published guidance.

The bottom line: It's all about communication
The new tip and overtime deductions are designed to benefit employees, but, without proper context, they could easily lead to confusion or frustration. Employers should take a proactive approach in messaging to avoid misconceptions that tips and overtime are suddenly "tax-free."

Although employers aren’t responsible for calculating or applying these deductions, they do serve as the first line of communication – making clear, consistent, and factual messaging critical.

These provisions are currently set to expire at the end of 2028, but more IRS guidance is expected, particularly around Form W-2 changes and qualifying job classifications. 

Until then, employers should focus on managing expectations and empowering staff with the tools they need to make the most of available deductions.