Claiming the Tax Deduction on Tips or Overtime: What You Need to Know

November 30th, 2025

The 2025 tax year rang in a major (albeit temporary) tax change for many workers, especially those who earn tips or overtime. Specifically, the One Big Beautiful Bill (OBBB) introduced two new deductions for individuals who receive tips or overtime compensation.

Although the bill was signed into law in mid-2025, these changes to the federal tax law were applied retroactively, which means people can claim them for the 2025 tax year.

In this article, we’ll go over what workers need to know about how these changes could affect end-of-year tax filings.

What Changed: Two New Deductions for 2025-28

The One Big Beautiful Bill, passed in July 2025, introduced a host of tax changes and updates, and that included a pair of new “above-the-line” deductions for individuals (subtracted from total gross income to calculate adjusted gross income). And because they’re above-the-line, people can claim these deductions whether they itemize or not.

These deductions are:

A deduction for “qualified tips” (for eligible occupations)
A deduction for “qualified overtime compensation” (specifically, the extra pay above regular wages required under overtime rules)

Both deductions were made retroactively effective as of Jan. 1, 2025, and apply through the 2025 to 2028 tax years.

“No Tax on Tips” Deduction

To claim the tip deduction, the tips must be “qualified tips,” which the IRS defines as:

Tips received by a person in a job that customarily and regularly received tips on or before Dec. 31, 2024. (You can see the proposed list of occupations in the Federal Register.)
Tips that are paid voluntarily, determined by the payor, and aren’t negotiated
Tips not received in the course of a trade or business specified by Section 199A(d)(2)

For the self-employed, the deduction for tips may not exceed the net income from the trade or business (excluding the tip deduction).

The deduction is limited to $25,000 annually, and it begins to phase out when a taxpayer’s modified adjusted gross income (MAGI) exceeds $150,000 (or $300,000 for joint filers).

Calculating Qualified Tips

Because this tax break was passed midyear, 2025 Form W-2 and 1099 haven’t been modified to account for the new tips reporting requirements. So for 2025, employes won’t be required to separately account for cash tips on the written statements they send to employees in 2025. They IRS lists the following four ways for calculating their qualified tips:

Use the total amount of social security tips reported in box 7 of the Form W-2.
Use the total amount of tips reported by the employee to the employer on all Forms 4070, Employee’s Report of Tips to Employer (or any similar substitute form used to monthly report tips to the employer)
If an employer voluntarily chooses to report the amount of an employee’s cash tips in box 14 of Form W-2 (or on a separate statement), the employee may use this amount in determining the amount of qualified tips for tax year 2025.
In addition to these three options, employees may also include any amount listed on line 4 of the 2025 Form 4137 filed with the employee’s 2025 income tax return (and included as income on that return).

Examples

Here are three examples of how tip deduction calculations would work, provided by the IRS in a recent guidance note:

“Ann is a restaurant server whose 2025 Form W-2, box 7 reports $18,000 of Social Security tips. Ann did not report any additional tips on Form 4137. Ann may use $18,000 in determining the amount of her qualified tips for tax year 2025.”
“Bob is a bartender who reports $20,000 in tips to his employer during the 2025 tax year on Forms 4070 and reports $4,000 of unreported tips on Form 4137, line 4. Bob’s 2025 Form W-2 reports $200,000 in box 1 and $15,000 in box 7. Bob may use either the $15,000 in box 7 of the Form W-2, or the $20,000 of tips reported to Bob’s employer on Forms 4070 in determining the amount of qualified tips for tax year 2025. Regardless of the option chosen, Bob may also include the $4,000 of unreported tips from Form 4137, line 4 in determining the amount of qualified tips.”
“Doug is a self-employed travel guide who operates as a sole proprietor. In 2025, Doug receives $7,000 in tips from customers paid through a third-party settlement organization (TPSO). For tax year 2025, Doug receives a Form 1099-K from the TPSO showing $55,000 of total payments. The Form 1099-K does not separately identify the tips. However, Doug keeps a log of each tour that shows the date, customer and tip amount received. Because Doug has daily tip logs substantiating the $7,000 tip amount, he may use the $7,000 tip amount in determining qualified tips for tax year 2025.”

As far as the deduction math itself is concerned, it’s pretty straightforward. If you earned $60,000 in total wages, but $30,000 of that was from tips, you would list $60,000 as income and $25,000 as a deduction. Why $25,000? That’s the maximum deductible amount. However, if you earned $20,000 in total wages, but all $20,000 of that income came from tips, you’d enter the whole $20,000 as the deduction, as it’s under the maximum.

“No Tax on Overtime” Deduction

For overtime, only the portion of overtime pay that exceeds the regular pay (so, typically the “half” portion of the “time-and-a-half” overtime wage) qualifies for the deduction.

The deduction limit is $12,500 annually for single filers and $25,000 for joint filers. And the overtime deduction is similar to the tip deduction in that it phases out based on MAGI thresholds ($150,000 single, $300,000 joint).

Examples

Again, the IRS has provided examples to help taxpayers understand how to deal with several situations concerning their overtime:

“Andrew works overtime during 2025, and he receives a payroll statement from his employer that shows $5,000 as the ‘overtime premium’ that he was paid during 2025. Andrew may include $5,000 (the FLSA overtime premium) to determine the amount of qualified overtime compensation received in tax year 2025. Assume the same facts as in the first example except that Andrew’s payroll statement shows a total ‘overtime’ amount of $15,000, which is the total amount Andrew was paid for working overtime (the FLSA overtime premium combined with the portion of his regular wages). Andrew may include the $5,000 FLSA overtime premium, computed by dividing $15,000 by three in determining the amount of qualified overtime compensation for 2025.”
“Brad’s employer has a practice of paying overtime at a rate of two times an employee’s regular rate of pay, and Brad was paid $20,000 in overtime pay during 2025. Brad’s last pay stub for 2025 shows “overtime” of $20,000 paid in 2025. For purposes of determining the amount of qualified overtime compensation received in tax year 2025, Brad may include $5,000 ($20,000 divided by four).”
“Carol is a covered, nonexempt employee under the FLSA and works in law enforcement and is paid $15,000 of overtime pay on a ‘work period’ basis of 14 days that complies with the FLSA. For purposes of determining the amount of qualified overtime compensation received in tax year 2025, Carol may include $5,000 ($15,000 divided by three).”
“Diane works for a state or local government agency that gives compensatory time at a rate of one and one-half hours for each overtime hour worked. In 2025, Diane was paid wages of $4,500 for compensatory time off based on that overtime. To determine the amount of qualified overtime compensation received in tax year 2025, Diane may include $1,500, one-third of these wages, for purposes of determining the qualified overtime compensation deduction.”

What Business Owners Should Know

If you own or manage a small or midsize business, especially in hospitality, food service, retail, entertainment, nail/beauty salons, rideshare or other industries where tipped or hourly/overtime workers are common, the 2025 changes have several implications:

Employers won’t be penalized in 2025 for failing to separately report tips or overtime pay. However, the IRS encourages them to provide as much helpful information as possible (e.g., via Box 14 on Form W-2, a supplemental annual statement, or an online portal).
Good recordkeeping is more important than ever. Providing clear documentation (occupation codes, separate tip/overtime statements) benefits employees — and protects your business, especially if the IRS expands reporting requirements in future years.
Employers should communicate with employees. Explain how the new deduction works, what documentation the employer will or will not supply, and encourage employees to maintain their own records.
Payroll and accounting systems might need updates down the line (especially after 2025) to properly report qualified tips and overtime — once the IRS rolls out updated forms, that is.
For businesses with a mix of tipped, hourly, overtime and/or salaried staff, careful classification and tracking will be especially critical to ensure compliance and to help your people maximize their benefit.

Do You Need Help With These New Deductions?

The new deductions for tips and overtime represent a significant shift — potentially leading to lower taxable income for many workers in service industries, hospitality, retail and beyond. For small- and midsize businesses, these changes present both opportunity and risk: opportunity to aid your workforce and build goodwill, and risk if records are poor or compliance is mishandled.

McManamon & Co. is ready to help clients navigate these new tax deductions, from tracking and substantiating tips/overtime to updating payroll systems, assisting with tax filings, and advising on compliance strategies.

If you or your employees receive tips or overtime, now is the time to get your records in order. And our tax specialists can help.

Want to know more? Reach out to us at 440.892.8900 or contact us online today.

Tags: McManamon, small business, tax deductions, taxes | Posted in McManamon & Co., small business, taxes