Payroll tax implications of new tax breaks on tips and overtime

The new One Big Beautiful Bill Act (OBBBA) is here, and it brings some significant, but temporary, changes to how tip and overtime income are taxed. If you're a business owner or an employee in an industry where tips and overtime are common, here’s what you need to know, without the technical jargon.

What's Changing?

Before this new law, all tip and overtime income was fully taxable. Now, the OBBBA introduces two new federal income tax deductions for the years 2025 through 2028.

1. A New Deduction for Tip Income

• What it is: You can now deduct up to $25,000 of your annual tip income from your federal income taxes. This isn't a free-for-all, though. The deduction starts to phase out if your modified adjusted gross income (MAGI) is over $150,000 ($300,000 for married couples filing jointly).
• Who qualifies? This deduction is for workers in jobs where tips are customary. The IRS is finalizing the list, but surprisingly, it might include professions like plumbers, electricians, digital content creators, and movers. However, certain fields like health, law, and accounting are ineligible.
• Good to know: This applies to both cash and credit card tips, and you can claim it whether you itemize your deductions or not.

2. A New Deduction for Overtime Income

• What it is: You can also deduct up to $12,500 of qualified overtime income each year (or up to $25,000 for married joint filers). This has the same income phase-out rules as the tip deduction.
• What counts as "qualified"? This is a bit tricky. The deduction only applies to the extra "half" in time-and-a-half overtime pay required by federal law (the Fair Labor Standards Act). Overtime premiums required by state laws or union contracts don't qualify. Tip income is also excluded.
• Good to know: Like the tip deduction, you can claim this even if you don't itemize.

Important Payroll and Reporting Details

You might have heard this described as "no tax on tips or overtime," but that's not quite right. These are deductions, not exclusions. This means:

• Federal payroll taxes (Social Security and Medicare) still apply to all your tip and overtime income.
• Federal income tax may still apply to some of your wages, and standard withholding rules are still in effect.
• This is a federal change, so your tip and overtime income might still be fully taxable at the state and local levels.

What Employers Need to Do Now

The biggest challenge for businesses is tracking and reporting this new "qualified" income so employees can claim their deductions.

• Reporting: Qualified tip and overtime amounts must be reported on forms like the W-2 or 1099-NEC.
• IRS Guidance: For now, the IRS has announced there will be no changes to tax forms for 2025. They want to give everyone time to adapt.
• Start Tracking Immediately: Employers should begin tracking qualified tip and income right away. You’ll also need to retroactively track any qualified income paid before the law was enacted on July 4, 2025. The IRS is expected to provide more guidance for the 2025 tax year and update forms for 2026.

Navigating new tax laws can be complex, but you don't have to do it alone. If you have any questions about how the OBBBA affects your business or payroll, our team at SD Mayer & Associates is here to help you find clarity.