In a September 24 article published by the National Taxpayers Union Foundation (NTUF), there is an explanation of the "no tax on tips" provision. This deduction was passed in the One Big Beautiful Bill Act (OBBBA). The NTUF article suggests this tax deduction will benefit a substantial number of individuals who receive voluntary tips. However, the deduction applies to individual income tax and not to the payroll tax. In addition, it will be important for all employees who receive tips to keep accurate records.

1. Income Tax Deduction — The new deduction exempts tip income up to $25,000 per year for single individuals and $50,000 per year for joint filers. The deduction is phased out for single individuals with incomes over $150,000 or a married couple with modified adjusted gross income over $300,000. It is applicable from 2025 until 2028. For example, a single individual with income of $45,000 in 2025 pays tax at 10% on the amount under $11,600 and 12% on the taxable income over that threshold. He or she can claim a standard deduction which will reduce taxable income by $15,000. Some individuals also may qualify for the Child Tax Credit (CTC) and Earned Income Tax Credit (EITC). These tax credits can potentially reduce the tax to zero. In 2022, an estimated 51 million taxpayers paid no federal income tax.
2. Payroll Taxes — While the new deduction is welcome, it applies to income tax and not to payroll tax. Payroll tax includes 6.2% for Social Security and 1.45% for Medicare. The 7.65% payroll tax is paid by both the employer and employee. The employer will need to record the tip amounts so that the correct payment is made for the employer tax. In addition, employers will need to withhold the 7.65% payroll tax for the reported tip income of employees. A high percentage of workers with income under $100,000 pay payroll tax. Approximately 70% of those taxpayers were paying payroll tax, but only 40% of them were subject to federal income tax. Because a substantial portion of tip income is self-reported, workers who receive this income need to ensure the amounts are reported to employers. With the correct amount reported to the employer, both the employer and employee 7.65% payroll tax will be paid.
3. Tip Income Reporting — The OBBBA "No Tax on Tips" law is a significant change for some taxpayers. However, it will require additional efforts to report the correct amounts. The Internal Revenue Service (IRS) has initiated the Tip Reporting Alternative Commitment (TRAC) and other systems to try to track tips. Because there are billions of dollars of tip income not reported, there will be continued efforts to increase the reporting of tips. A new initiative by the IRS is the Service Industry Tip Compliance Agreement (SITCA). This is still in the process of being implemented. With the new deduction, both employers and employees will want to be more accurate in tip reporting.

When employees who receive tips file tax returns, they will need guidance from the IRS. The IRS was required by OBBBA to specify the occupations that qualify for the tip deduction. The IRS has also issued a proposed Schedule 1-A that helps employees determine whether they qualify for the full tip deduction. If the wages for a single person are less than $176,100 on their W-2, then they can use the Schedule 1-A form to learn if they are qualified.

Employees also need to know whether their specific occupation qualifies. The IRS has published nearly 70 qualifying occupations under the Treasury Tipped Occupation Code (TTOC). The IRS also notes this deduction applies to voluntary cash tips. Cash can include tips paid with credit cards, debit cards, casino tips or gift cards. Some restaurants with a mandatory service charge may change policies to allow a voluntary tip that qualifies for the new deduction.

The Yale Budget Lab estimated in 2022 that approximately 37% of tipped workers paid no federal income tax. These individuals will not be affected by the new deduction. However, individuals in higher tax brackets who receive tips will significantly benefit from the “no tax on tips” deduction.