What do new tax rules for tips and overtime mean for employers?
The One Big Beautiful Bill (OBBB) provides strategic opportunities for employers to reevaluate compensation structures in ways that attract labor and boost employee satisfaction beginning in 2025. Two key changes for you to assess are new deductions for overtime and tips.
These have been casually, if slightly misleadingly, referred to as “no tax on tips” and “no tax on overtime.” Both deductions have gotten a lot of attention but may not function exactly the way you expect.
Keep reading to learn key facts about the OBBB rewrites tax law for tips and overtime and what that could mean for your business.
What is the no tax on tips deduction?
The tip deduction allows employees to exclude up to $25,000 in qualified tips from their taxable income, subject to income limits. However, only voluntary tips in an occupation that customarily receives tips are eligible.
- Automatic gratuities and mandatory service charges are treated as regular wages and do not qualify.
- The exemption on voluntary tips is not realized through a payroll adjustment, but instead the employee must claim the deduction on their personal tax return.
- It is important to note that highly compensated individuals are not eligible for the deduction.
When does the no tax on tips deduction start?
The new tax deduction on tips takes effect for the 2025 tax year. However, the provision is time-limited and scheduled to sunset after 2028.
How does the no tax on tips rule affect employers in 2025?
The new rules around taxing tips present an opportunity for employers to adjust their tip structure. Employers should consider removing automatic gratuities in certain situations, which would then qualify the voluntary tips for the deduction. By shifting more tips to a voluntary basis, employees will be able to claim a larger deduction on their tax return and keep more money in their pockets.
However, be aware that key employer responsibilities have not changed. Employees are still required to report their tips to employers, who must then issue employees a W-2 that documents those tips.
Tips are also still subject to tax withholding, including federal, state, local, Social Security and Medicare taxes when applicable.
What is the new no tax on overtime deduction?
In addition to the tip income exclusion, the OBBB also included a federal tax deduction for eligible overtime pay. Although employers must continue withholding applicable payroll taxes, employees may deduct up to $12,500 ($25,000 if married filing joint returns) in qualified overtime compensation on their personal returns. This is also subject to income limitations.
- As with the tip deduction, highly compensated individuals are not eligible.
- Only the premium portion, or the additional wages on top of the base wage, is eligible for this deduction. For example, if an employee earns a base $20 an hour salary, and their overtime rate is $30 an hour, the $10 per hour over the base of $20 an hour is the premium portion that is eligible for the deduction.
- While IRS guidance on reporting is pending, it is known that overtime compensation provided under more generous state laws, collective bargaining agreements (CBAs), or employer discretion does not qualify for this exemption.
When does the no tax on overtime deduction start?
The new tax rules for overtime take effect starting with the 2025 tax year. The overtime tax deduction is scheduled to end after 2028.
What else should employers know about the new overtime tax rule?
Just like the changes to taxing tips, employers should know that their responsibilities regarding overtime pay remain largely the same. Employers still need to document overtime paid out to employees on a W-2.
Overtime pay also remains subject to all typical tax withholdings, like federal, state, local and payroll taxes.
The new tip and overtime tax rules can help employers strengthen employee retention
The new tip and overtime tax rules give employers a new tool to appeal to employees and boost retention. This can provide a competitive advantage to employers who understand the new rules over those who don’t or who haven’t considered the implications from a retention perspective.
In the event that finding sufficient labor staffing is a problem, employers can encourage employees to commit to additional hours by educating their employees on the benefit of the overtime deduction. While tax reporting for payroll remains unchanged, these deductions may influence employee-level planning and could incentivize current employees and new hires.
To do this most effectively, take the time to consider how your current pay structures work and what the new rules could offer your employees. Understand the benefits from an employee perspective so that you can do a better job of communicating them.
The more clarity you can offer here, the better. As the new tip and overtime rules only affect federal taxes, you should also make sure employees understand this distinction so that no one is surprised when they file their taxes.
Remember, these deductions aren’t just tax perks — they’re tools for shaping workforce behavior. Employers who proactively adjust compensation structures and educate their teams can transform compliance into a competitive advantage in hiring, retention and employee satisfaction.
How Wipfli can help
Stop thinking of tax as a burden and begin seeing it as a growth tool for your business. Ask our team of tax advisors to assess how changing tax law affects your specific circumstances and develop a tax strategy to benefit you. Start a conversation.
Build your tax strategy
