NO TAX ON TIPS?

The statement “No Tax on Tips” in relation to the recently passed tax legislation is misleading.

The so-called “One Big Beautiful Act”, signed into law on July 4th, did not exempt all tips from all federal taxes.  The Act created a federal income tax deduction for up to $25,000 in tips received for tax years 2025 through 2028, phased out based on your “Modified” Adjusted Gross Income (MAGI).  For this deduction MAGI is your Adjusted Gross Income plus any exclusion for foreign income or income from Puerto Rico, Guam, American Samoa, and the Northern Mariana Islands.

There is no change to how tips are reported.  Employees must still report tips received to their employer and the employer must still withhold, and match, the 7.65% FICA (Social Security and Medicare) tax and pay FUTA (federal unemployment) tax on the tip income.  Employers received no tax benefit related to tip income in the new law.

As in the past, employers will include tip income in the amount reported as “wages, tips, other compensation” in Box 1 and “Medicare wages and tips” in Box 5 of your 2025 Form W-2.  Tips will be separately reported as “Social Security tips” in Box 7.  Qualified tips will probably also be separately reported in Box 12 or Box 14 (tips that qualify for the deduction may be different from reported “Social Security tips”) and your occupation will probably be reported in Box 14.

And, also as in the past, you will report the amount from Box 1 of all W-2s on Line 1a of your 2025 Form 1040 (or 1040-SR).  What you will now be able to do is claim a deduction for up to $25,000 of qualified tips (as identified on your Form W-2), which reduces your federal net taxable income. 

The amount of the maximum deduction you can claim for qualified tips is reduced by $100 for every $1,000 (or fraction thereof) that your MAGI exceeds $150,000, or $300,000 if you are married and filing a joint return with your spouse. 

Qualified tips are cash or credit card tips voluntarily paid by the customer or distributed through tip-sharing arrangements for voluntary tips.  Mandatory service charges or automatic gratuities for large parties do not qualify.  Only tips received in “an occupation that customarily and regularly received tips on or before December 31, 2024” qualify for the deduction.  The IRS will be issuing a list of qualified occupations by October 2nd – but restaurant and tavern and hotel and motel service staff will certainly be on the list.  Tips you report on Form 4137 (Social Security and Medicare Tax on Unreported Tip Income) may also qualify for the deduction.

This is not an itemized deduction.  You can claim the deduction for tips whether or not you itemize your deductions on Schedule A.  For married individuals the deduction is only available if you file a joint return.  This new deduction is not available on “Married Filing Separately” returns.  It appears the $25,000 maximum is per return and not per taxpayer.

The Act does not change the state tax treatment of tip income.  Your tips will still be subject to any state income tax and state payroll tax.

So, you could be paying no federal income tax on your tips.

My personal opinion –

As I have posted in the past, from a financial, economic, and “tax fairness” point of view the “No Tax on Tips” and “No Tax on Overtime” deductions make absolutely no sense. 

Tip and overtime income is W-2 earned income.  Why do restaurant and tavern and hotel and motel service employees deserve a special tax deduction and secretaries and clerks do not?

Promises of these new special deductions were “gimmicks” that were used to “buy” votes in the 2024 Presidential election – made by a candidate known for not keeping his campaign promises.  I am truly surprised that these promises were actually made law. 

To be honest, when Trump proposed especially the “no tax on tips” deduction I very seriously believe he intended a total exemption from all federal tax on tip income – including an exemption from payroll taxes.  In such a case the big winner would not be tipped employees but resort owners like Trump who hire tipped employees – allowing Trump and friends to save millions on the FICA tax match.  But if federal payroll taxes were exempt the beneficiary tipped employees would lose out in the long run from reduced Social Security income at retirement.  Thankfully the tax writers created a federal income tax deduction – and did not make any changes to how tips are reported by employers and kept the FICA employee withholding and employer match.

If Congresscritters believed low-income employees deserved a tax break it should have created a deduction for all service employees (i.e. not professional employees) with a MAGI phase-out.

TTFN