Employees Can Deduct Up to $25K in Tips and $12.5K in Overtime Starting 2025
The recently signed One Big Beautiful Bill introduced two headline‑grabbing provisions: “No Tax on Tips” and “No Tax on Overtime.”
For the first time, employees will be able to deduct significant amounts of their tip income and overtime pay from federal income taxes starting with wages paid in 2025.
This change is one of the most discussed tax changes in years, and it is already raising questions from employers and employees alike.
This guide explains what the new rules mean, what is not changing, and what steps you should take to prepare.
What Does “No Tax on Tips and Overtime” Mean?
Buried in nearly 1,000 pages of the One Big Beautiful Bill, Congress introduced two new deductions: one for tip income and one for overtime.
This new law allows employees to deduct tip income and overtime pay from their federal income taxes starting with wages paid in 2025.
- Employees can deduct up to $25,000 in tips each year.
- Employees can deduct up to $12,500 in overtime pay each year.
For married couples filing jointly, those amounts double to $50,000 in tips and $25,000 in overtime.
This is a deduction at tax time
This deduction is taken on the employee’s individual tax return. Their weekly paycheck will not change automatically because payroll systems will still withhold taxes the same way.
The entire overtime rate qualifies
This is important! The deduction applies to the full 1.5x overtime rate, not just the “extra half” that is paid above normal wages.
This deduction will run through 2028 unless Congress extends it.
This is significant for industries like restaurants, salons, hotels, manufacturing, and construction, where tips and overtime make up a big part of paychecks.
But before you assume this means employees stop paying taxes on those dollars, there’s an important distinction you need to understand.
Deduction vs. Credit: Why Employees May Be Disappointed
These are deductions, not credits! The difference matters.
- A credit reduces taxes dollar for dollar.
- A deduction simply lowers taxable income, and the actual tax savings depend on the tax bracket.
For example, if someone earns $10,000 in overtime and is in the 10% tax bracket, they save about $1,000 in taxes. If they are in a higher bracket, they save more, but it is never dollar for dollar.
This one point—deduction vs. credit—sets the stage for much of the confusion that employers will need to clear up.
Misunderstandings About 'No Tax on Tips and Overtime' That We Need to Clear Up
With a headline like “no tax on tips,” it’s no surprise that employees might jump to conclusions.
#1: Employees Won’t See Automatic Paycheck Changes
This deduction is taken on the employee’s individual tax return. Employees will not see larger checks unless they adjust their W‑4. Payroll will continue to calculate and withhold taxes on tips and overtime as usual. Most will only see the tax benefit when they file their return.
#2. FICA Taxes Still Apply
FICA taxes are completely unaffected by these changes. Employees still pay 7.65% in Social Security and Medicare taxes on every dollar. Employers still pay the matching 7.65% on all compensation. This applies to all tips and overtime wages.
The "no tax" language only refers to federal income tax deductions. Social Security and Medicare taxes continue on the full amounts.
#3. This Is Not A Payroll “Tax Holiday”
Tips and overtime are not tax-free. The deduction only applies to federal income tax at filing time.
#4: Businesses Do Not Have To Rebuild Payroll
Your payroll system does not need to be restructured. Employers will keep reporting and withholding taxes exactly as they have. What may change is the W-2 format. Tips and overtime will likely get their own reporting box to make tax filing easier.
Enhanced W-2 Reporting Requirements
Expect your W-2 forms to include new information to help employees claim these deductions. Overtime wages will likely appear in Box 12 or 14. Tip income will be separately tracked and reported. This information helps employees and their tax preparers easily identify qualifying amounts.
Most payroll software providers are already building this functionality, so the reporting should be seamless for employers.
How Employees Can Adjust Their W‑4 to See the Benefit Sooner
Employees don't have to wait until tax time. They can adjust their W-4 form now to reduce withholding throughout the year.
- On the W‑4, there’s a section called "Other Deductions".
- If an employee regularly earns tips or overtime, they can enter those expected amounts.
- For example, a server who expects $25,000 in tips in 2025 can enter that number on their W-4.
This reduces their federal income tax withholding on each paycheck rather than waiting for the tax return next spring.
W-4 Considerations
Employees should be conservative in their estimates. Overestimating could mean owing money at tax time. W-4 forms are more complex than they used to be. Consider encouraging employees to consult a tax professional for guidance.
While employees may adjust their W‑4, employers have their own checklist to prepare for.
What Changes for Employers
No Change to Your Costs
From a business perspective, you don't pay less in payroll taxes. Your labor costs remain the same. The changes are primarily administrative.
Enhanced Record-Keeping
Maintain detailed overtime records (hours, rates, calculation methods). Keep accurate tip reporting records throughout the year. Document all W-4 changes with dates and amounts. Prepare for potential IRS questions about large withholding adjustments.
Employee Communication
Your main job is managing expectations and providing accurate information. Explain that paychecks won't change automatically. Clarify the difference between deductions and credits. Show employees the W-4 option without giving tax advice. Set realistic expectations about actual savings.
Want ready-to-use scripts and templates for explaining this to employees? Read A Manager’s Guide to Employee Questions About the One Big Beautiful Bill.
State Tax Implications
Most states will likely not conform to these federal deductions. State income tax withholding continues on full wages. State unemployment taxes are calculated on total compensation. Workers' compensation premiums are based on total wages. Only federal calculations change.
This creates potential confusion for employees who may expect state tax benefits as well.
Compliance and Audit Considerations
What the IRS Will Watch
The IRS will likely scrutinize employees claiming maximum deductions without corresponding earnings, businesses with unusual tip or overtime reporting patterns, and W-2s that don't match actual payroll records.
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Documentation Requirements
Maintain detailed overtime documentation including hours and rates. Keep accurate tip reporting records including daily tip reports and credit card tips. Document any W-4 changes related to these deductions. Prepare for potential IRS questions about large withholding adjustments.
The Conversation That's Coming
The One Big Beautiful Bill might carry a $5 trillion price tag, but here's what actually matters: how you handle the next conversation with an employee who walks into your office expecting a bigger paycheck.
Will you be the employer who scrambles to explain why their Friday stub looks identical to last week's? Or will you be the one who saw this coming, prepared your team, and turned a potential disappointment into a teachable moment about real financial benefits?
The "no tax on tips and overtime" provisions aren't revolutionary—they're evolutionary. They provide meaningful help for workers in the right industries, but they require something that no legislation can mandate: clear and honest communication.
Ready to handle these conversations like a pro? Our Manager's Guide to Employee Questions About the One Big Beautiful Bill gives you the scripts, templates, and talking points you need to turn confusion into confidence.
