Keep the Change: No Tax on Tips and Overtime
As part of the sweeping federal tax reform bill, the One Big Beautiful Bill Act aims to provide meaningful tax relief for America’s service and hourly workforce by allowing taxpayers to deduct reported tip income and overtime pay from federal income tax. While this change could provide a financial cushion for working-class individuals, the legislation also creates a logistical minefield.
The new law will make it harder for employers to file reports, and it will make tax returns much more complicated for many employees. This is especially true as states like New York, Washington D.C., Virginia and Maryland will decide whether to follow the federal change and allow deductions related to overtime and tips. As of December 2025, many states have not yet taken a definitive position and are expected to evaluate the OBBBA during their 2026 legislative cycles. Employers will face complex implementation challenges, including updating payroll and reporting systems to separately track the taxable and potentially deductible portions of tip and overtime income. Despite the large payroll modifications required, the relief is temporary, set to expire in 2028. Taxpayers and employers could face challenges shifting reporting systems yet again, accounting for tax withholding adjustments, and recalibrating lifestyles once the tax break ends.
What’s on the Table
“No Tax on Tips” Deduction
· Deduction: up to $25,000 in tipped income; employers and other payors must report the tips starting in 2026.[1] For the self-employed, the deduction may not exceed the individual’s net income from the trade or business in which the tips were earned.
· Phaseout: Begins at $150K AGI ($300K joint) at a 10% rate.[2]
· Limitation: Applies only to an occupation that customarily and regularly receives tips and that the amount is paid voluntarily without any consequence in the event of nonpayment, is not subject to negotiation, and is determined by the payor; IRS-listed “tipped occupations.” Accountants, lawyers, doctors and other Specified Service Trades or Business do not qualify.[3]
· Timing: 2025–2028.[4]
· Caveats:
o Still required to pay Social Security and Medicare tax even if no income tax.
o Taxpayers must file jointly if married;[5] only applies to “qualified tips” for an eligible occupation.
o In 2025, employers are not required to report “qualified tips” and employees are responsible for keeping their own records and reporting properly.
“No Tax on Overtime” Deduction
· Deduction: up to $12,500 ($25K joint) of the premium portion of Fair Labor Standards Act (FLSA) overtime even for non-itemizers.
· Phaseout: Begins at $150K AGI ($300K joint) at a 10% rate.
· Limitation: “Qualified overtime compensation” refers to the portion of overtime pay that exceeds an employee’s regular hourly rate, as required under the FLSA.[6]
· Timing: 2025–2028.[7]
· Caveats:
o Still required to pay Social Security and Medicare tax even if no income tax.
o Taxpayers must file jointly if married[8]
o Only includes the amounts of overtime that exceed the FLSA definition, which may differ from employers’ or state mandated definition of overtime.
o In 2025, employers are not required to report “FLSA overtime” and employees are responsible for keeping their own records and reporting properly.
Important Caveats
Many Taxpayers will be surprised to learn that while there is no income tax on tips and overtime wages, Social Security or Medicare payroll tax obligations still apply. Employers must continue to withhold and report all tip and overtime earnings as usual. As a result, affected workers will likely need to wait until they file their tax returns to receive their benefits unless withholdings are adjusted.
To claim the new federal deduction for tips, workers must meet two main criteria: tip-eligible employment as determined by IRS guidance and receipt of “qualified tips.” The proposed regulations outline a strict definition: (1) tips must be voluntarily paid by customers, (2) made in cash or cash equivalents, (3) determined by the payor, and (4) either directly received or distributed through a recognized tip-sharing arrangement. Importantly, automatic service charges (e.g., a mandatory 18% gratuity for large parties) do not qualify, even if ultimately disbursed to staff.
To claim the “no tax on qualified overtime” deduction, only the portion of overtime pay the FLSA requires is eligible. Since the FLSA mandates overtime at rate of time-and-a-half, if an employer pays double time, the additional half-time premium beyond the FLSA requirement does not qualify for the deduction. Adding to the complexity, overtime rules can vary significantly by employer. Some provide it for working over 37.5 hours per week (especially state/federal agencies), others for exceeding 10 hours in a single day, and still others provide it for all work performed on weekends and holidays. However, since not all of these payments meet the FLSA's 40-hour workweek standard, employees may receive "overtime pay" that is still fully taxable, creating confusion and misreporting.
For 2025, the IRS has exempted employers from tracking qualified tips or FLSA overtime. Therefore, employees are responsible for determining which portion of their overtime and which portion of their tips, if any, qualify for the deduction.
While there is confusion and logistical hurdles surrounding the provisions for employers and employees, expect the IRS to continue to issue updated guidance, as they have with IRS Notice 2025-69, to try to help taxpayers comply with the law. The IRS is expected to introduce additional W-2 codes or reporting fields to allocate exempt tips and overtime. States aligning with these deductions will likely revise their withholding frameworks to reflect the federal approach, while non-conforming states are anticipated to direct employers to maintain existing withholding methods.
Employer Reporting Challenges
The administrative burden for businesses will center around payroll and point of sale systems. Likely the increased compliance costs will disproportionately challenge small businesses.
Partial Overtime Exclusion: Only the extra portion of overtime pay is excluded from tax, meaning companies must build logic into accounting systems to calculate and separate base pay from the FLSA overtime premium. Accountants will need to verify and track the tax-free portion, and the additional accounting fees for employees may offset the some of the benefit of the deduction.
Tip Allocation Complexities: Employers will now need to determine which employee receives each portion of reported tips, including resolving discrepancies between pooled tips and individual allocations. This creates serious tracking issues, especially in high-volume service settings.
New Systems Implementation: Employers will need to modify payroll systems to identify and separately report qualified tips and allocate overtime income as FLSA overtime income. This will require updates to software, extra data entry, and additional training for HR departments. These investments could have limited use if the deduction is not extended past its current sunset date in 2028.
State-Level Discrepancies
Federal-State Mismatch: Some states, including Washington D.C., have indicated they will not conform to the new federal treatment of tip and overtime income. This creates a dual reporting burden for taxpayers who may benefit federally but will still owe state tax. Additionally, they may face increased accounting costs to comply adding to the burden.
Audit Headaches Ahead: The mismatch increases the complexity of state-level audits and could invite more scrutiny from both state and federal tax authorities.
Temporary Relief, Permanent Complications
2028 Sunset Clause: The deduction is only authorized through 2028, after which the pre-reform rules will automatically come back creating a significant tax increase to eligible workers.
Administrative Whiplash: Employers will again have to retool systems to remove the deduction tracking, leading to a back-and-forth policy change that adds instability to payroll administration.
Policy Implications
The One Big Beautiful Bill provisions on "no tax on tips and overtime" are believed to have emerged from bipartisan concerns about the regressive nature of payroll taxation and the economic uncertainty faced by low-wage earners. Supporters of the bill state that inconsistent income, like tips and overtime, disproportionately impacts lower-income Americans, making predictable tax treatment a form of economic justice. In the Biden administration, there was a push for greater transparency in the service economy related to tips, where much of tip income goes unreported. By offering above-the-line deduction, some believe, the policy will encourage more people to report their tips and give workers a fiscal cushion without creating new credit programs.
Tax cut provisions reduce the revenue otherwise scheduled to flow into the federal government. According to the nonpartisan Joint Committee on Taxation (JCT), the “no tax on overtime” deduction is estimated to cost about $81.5 billion over the current period of the provision from FY 2025 through FY 2028.[9] The “no tax on tips” deduction is estimated to cost about $26 billion over the same period.[10]
Taken together, the tips and overtime provisions that proponents argue reflects a shift in tax policy that prioritizes equity and transparency over administrative simplicity. However, others argue it does not create equity because low-income jobs that do not rely on tips do not get similar relief and are therefore treated worse under the tax code. While the deductions offer short-term relief to millions of low-wage and service workers, they also come with a fiscal cost projected to exceed $100 billion once full implementation is accounted for. Whether Congress extends or allows these provisions to expire will be a key indicator of future priorities. Either way, the policy’s success will hinge not just on intent, but on execution and clarity, and staying power.
Wrapping It All Up
The One Big Beautiful Bill’s tip and overtime deductions are intended to provide tax relief for working class Americans. However, its success will be challenged by interpretive gaps, administrative burdens, and a ticking policy clock. Employers are left to navigate compliance risks, payroll system overhauls, and the possibility of future reversals. Similarly, workers may benefit in the short term by keeping more of their hustle, but the looming 2028 expiration, unclear IRS rules, and state-level decoupling threaten to create significant complexity that may eliminate much of the benefit that the bill intended.
[1] SEC. 224. QUALIFIED TIPS. (b), (h); https://www.irs.gov/newsroom/one-big-beautiful-bill-act-tax-deductions-for-working-americans-and-seniors
[2] SEC. 224. QUALIFIED TIPS. (b)(2)(A)
[3] SEC. 224. QUALIFIED TIPS. (d); https://www.irs.gov/newsroom/one-big-beautiful-bill-act-tax-deductions-for-working-americans-and-seniors
[4] SEC. 224. QUALIFIED TIPS, (h)
[5] SEC. 224. QUALIFIED TIPS. (e)
[6] ‘‘SEC. 225. QUALIFIED OVERTIME COMPENSATION (a), (b)
[7] ‘‘SEC. 225. QUALIFIED OVERTIME COMPENSATION (g)
[8] ‘‘SEC. 225. QUALIFIED OVERTIME COMPENSATION (e)
[9] https://www.jct.gov/getattachment/d24ad2f9-6afb-46cc-9688-a2d07c375f0e/x-30-25.pdf
[10] https://www.jct.gov/getattachment/d24ad2f9-6afb-46cc-9688-a2d07c375f0e/x-30-25.pdf