New Deductions for Overtime Pay and Tips

Overtime Pay and Tips (1)
January 2026

In July 2025, Congress enacted the One Big Beautiful Bill Act (H.R.1), creating new federal tax deductions for overtime and tip income. Under this law, individuals can deduct qualifying overtime wages and tips, up to the limit, on their federal income tax return for tax years 2025–2028. (Remember: this change does not affect Social Security/Medicare (FICA) taxes or any state taxes.) In practical terms, workers will still see normal withholding on paychecks in 2025 but can claim refunds via these deductions when they file their income tax return for 2025. Below we explain how the new rules work for employers and employees, and which jobs qualify for the deductions.

No Federal Income Tax on Overtime Pay

Under the new law, employees who receive overtime wages under the Fair Labor Standards Act (FLSA) can deduct the premium portion of their overtime pay. “Qualified overtime” is the extra half of time‑and‑a‑half pay required by law.

For example, if your base wage is $20/hr and your overtime rate is $30/hr, the extra $10/hr is eligible. The deduction is capped at $12,500 per year for single taxpayers ($25,000 for joint filers). It phases out at higher incomes (beginning at $150,000 modified adjusted gross income (MAGI) for single filers and $300,000 for joint filers). Note this only covers federal income tax – you and your employer must still withhold and pay Social Security, Medicare and state and local income taxes on overtime. Also, only FLSA-required overtime counts. Any overtime paid under state law, union contract, or voluntarily over the FLSA requirement is not eligible.

Practical tip: For tax year 2025, IRS guidance lets employers use a “reasonable method” to estimate each employee’s qualified overtime premiums. Employers are encouraged to report overtime premiums separately so employees can claim the deduction (for example, noting the overtime‑premium amount on pay stubs or in W-2 Box 14). Starting in 2026, the IRS plans a new W-2 code (“TT” in Box 12) specifically for qualified overtime.

No Federal Income Tax on Tips

Similarly, the law creates a new deduction for tips. Voluntary cash and credit card tips that an employee receives can be deducted on federal income tax returns for 2025–2028. The deduction is limited to $25,000 of tips per year. Like overtime, it phases out above $150,000 MAGI (single) or $300,000 (joint). This applies to both employees and certain self-employed (e.g. sole‑proprietors) in tipped jobs, as long as the tips are in covered occupations. Tips must be reported on a Forms W-2, 1099, or related statement to qualify. Tips that are not voluntary – e.g. mandatory service charges or automatic gratuities – are excluded. As with overtime, Social Security, Medicare and state and local income taxes still apply to all tip income.

Eligible Jobs and Industries

The “no tax on tips” break only applies to jobs where tipping was historically common. The IRS has identified dozens of occupations in eight major categories as eligible. Examples include:

  • Beverage & Food Service – e.g. bartenders, wait staff, restaurant cooks and helpers.
  • Entertainment & Events – e.g. musicians, DJs, dancers, casino dealers, ticket takers.
  • Hospitality (Hotels/Resorts) – e.g. hotel front‑desk clerks, bellhops, housekeepers.
  • Home Services – e.g. plumbers, electricians, landscapers, appliance repairers, home cleaning workers.
  • Personal Care & Appearance – e.g. barbers, hairstylists, massage therapists, fitness instructors.
  • Recreation & Instruction – e.g. tour guides, sports instructors, golf caddies.
  • Transportation & Delivery – e.g. taxi/ride‑share drivers, valet attendants, delivery couriers.

Notably excluded are tips from jobs in high‑income professional fields (e.g. health care, law, finance, consulting, most performing arts/athletics), since those industries are classified as “specified service” trades and do not qualify. For anyone earning tips: keep detailed records or logs of tips in case you need to prove tip income, as IRS guidance allows.

What Employers Need to Do

  • Payroll withholding: For 2025, employers should have withheld federal income tax, Social Security, Medicare and state and local income taxes on all wages (including overtime and tips) as before. Employees will recover a portion of the federal income tax withheld when they file their 2025 federal income tax return.
  • Overtime recordkeeping and reporting: Track overtime premiums separately. Even if you didn’t know about this before July 2025, estimate 2025 overtime pay that qualifies (since the law is retroactive). You might provide employees a year‑end statement or use Box 14 on Form W-2 in 2025 to show “overtime premium” amounts. In 2026, use Form W-2 Box 12 code TT to report qualified overtime.
  • Tip recordkeeping and reporting: For 2025, you can estimate total cash tips (since the law is retroactive) and report them to employees (for example via Form W-2 Box 14). In 2026, use Form W-2 Box 12 code TP to report qualified tip income and Box 14b to report the Treasury Tipped Occupation Code.
  • Communication: Explain these changes to staff. Make clear that only federal income tax is affected – Social Security, Medicare and state and local income taxes are still withheld.

What Employees Need to Know

  • Continued reporting: You must report all your tips to your employer (via Forms 4070, pay‑stubs, etc.) and on your tax forms if unpaid by employer. Any tips you didn’t report during the year are reported on Form 4137 to figure the Social Security and Medicare tax owed.
  • Filing your 2025 tax return: When you file your 2025 federal return, you may be able to claim deductions for your qualified overtime and tip income. These deductions are reported Form 1040, Schedule 1-A. To calculate the deductions, you’ll use your Form W-2, paystubs and tip records. For example, if your Form W-2 Box 7 shows $18,000 in tips, you can deduct $18,000 (up to the limit). If you kept additional tip logs, reported tips on Form 4070 or filed Form 4137, you can use those amounts too. Likewise, deduct the overtime “premium” you earned (up to the limit). IRS examples clarify you should use the extra half of any time‑and‑a‑half pay. The result: a dollar‑for‑dollar reduction of your taxable income, yielding a refund of federal income tax previously paid on that income.
  • Watch your paychecks: On your 2025 paystubs, federal income tax will still be withheld on overtime and tips as before. Don’t expect a higher take‑home pay right away – the benefit comes as a tax refund or reduced tax owed next year.
  • Keep good records: Retain copies of pay stubs, tip logs, Forms 4070 and 4137, and any employer statements of tips and overtime. If the IRS ever asks, these documents support the deductions.

Key Points

Even though federal income tax is waived on this income, the overtime premiums and tips must be reported accurately. For employers, this means separating and documenting overtime premiums and tips on payroll records (with transition relief for 2025). For employees, it means reporting tips and checking that your Form W-2 (and later, your income tax return) reflects the correct amounts. By following IRS guidance, employees can confidently claim these new tax deductions.

If you have any questions on how the new deductions could impact you, please reach out to our team.

This content is for informational purposes only and does not constitute tax or legal advice. Please consult a qualified advisor regarding your individual circumstances.