The One Big Beautiful Bill: What Employers Need to Know About the New Overtime and Tips Deductions

The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, introduced significant tax changes affecting how employers report overtime and tip income. While marketed as "no tax on overtime" and "no tax on tips," these provisions are actually federal income tax deductions—not exemptions—with specific rules employers must understand.

This guide covers what payroll professionals need to know: what qualifies, how to report it, and what changes are coming in 2026.

Overview: What Changed

The OBBBA created two new above-the-line tax deductions for employees:

Deduction	Maximum Amount	Income Phase-Out Starts	Effective Period
Qualified Overtime	$12,500 single / $25,000 joint	$150,000 single / $300,000 joint	2025-2028
Qualified Tips	$25,000	$150,000 single / $300,000 joint	2025-2028

Both deductions phase out by $100 for every $1,000 of modified adjusted gross income (MAGI) above the threshold. At $275,000 single ($550,000 joint), the overtime deduction is fully phased out. The same applies to tips at those income levels.

Important: These are temporary provisions. Unless Congress extends them, tips and overtime will be fully taxable again starting in 2029.

The "No Tax on Overtime" Deduction

What Qualifies as Overtime

Only the premium portion of FLSA-required overtime qualifies for the deduction. That means:

The "half" portion of "time-and-a-half" pay
Only overtime required under the federal Fair Labor Standards Act (FLSA)
Only for non-exempt employees

What does NOT qualify:

The base hourly rate for overtime hours (just the premium)
State-mandated overtime beyond FLSA requirements
Union-negotiated overtime beyond federal minimums
Voluntary overtime pay beyond what FLSA requires
Pay to exempt employees (executive, administrative, professional, outside sales, highly compensated employees)

Calculating the Deductible Amount

If an employee earns $30/hour normally and receives $45/hour for overtime, only the $15 premium qualifies for the deduction—not the full $45.

Example:

Regular rate: $25/hour
Overtime rate: $37.50/hour (time-and-a-half)
Overtime hours worked: 200 hours in 2025
Total overtime pay: $7,500
Qualified overtime compensation (the premium): $2,500 (200 hours × $12.50)

The employee can deduct the $2,500, not the full $7,500.

Who Can Claim It

W-2 employees who are non-exempt under FLSA
Must have a valid Social Security number
Cannot use Married Filing Separately status
Independent contractors: IRS guidance is still pending on contractor eligibility

The "No Tax on Tips" Deduction

What Qualifies as Tips

Only "qualified tips" in specific occupations are eligible:

Requirements:

Tips must be voluntary—not service charges or automatic gratuities
Must be in an occupation that "customarily and regularly received tips" before December 31, 2024
Must be reported on Form W-2, 1099, or Form 4137

What does NOT qualify:

Mandatory service charges (e.g., 18% added for large parties)
Automatic gratuities that customers cannot modify
Tips received from your employer or someone you have an ownership interest in
Amounts for performing illegal activities, or given because of a threat

Exception: If a customer voluntarily adds an extra tip on top of an automatic gratuity, that additional amount may qualify.

Qualifying Occupations

The Treasury published a list of Treasury Tipped Occupation Codes (TTOC) covering occupations that customarily received tips. Categories include:

Restaurant workers (servers, bartenders, hosts, bussers, kitchen staff in tip pools)
Hotel staff
Valet parking attendants
Hair stylists, barbers, manicurists
Spa workers
Golf caddies
Entertainers
Digital content creators
And many others

If the employee's occupation is on the list and they receive voluntary tips, those tips likely qualify.

What Employers Must Do

For Tax Year 2025 (Transition Year)

The IRS has provided penalty relief for 2025. You are not required to separately report qualified overtime or tips on W-2s this year. However, you are encouraged to help employees by:

Providing qualified overtime amounts via:
- Box 14 of Form W-2
- Final pay stub for the year
- Separate written statement
- Online portal
Providing qualified tip amounts via:
- Box 14 of Form W-2
- Separate statement
- Employee's occupation code (TTOC)

No penalties will apply for 2025 if you don't separately report these amounts, as long as your W-2s are otherwise accurate.

For Tax Year 2026 and Beyond

Starting in 2026, separate reporting becomes mandatory:

Overtime:

Report qualified overtime compensation in Box 12 of Form W-2 using a new code (draft code: "TT")
Separately identify the FLSA overtime premium portion

Tips:

Report qualified tips in Box 12 of Form W-2
Report the Treasury Tipped Occupation Code (TTOC) in a new Box 14b
For contractors, report in new Box 1b of Form 1099-NEC with TTOC in Box 1c

Penalties for non-compliance starting in 2026 range from approximately $60 to $680 per incomplete W-2.

Payroll System Changes You Need to Make

Immediate (2025)

Document your methodology for identifying qualified overtime
Decide how you'll communicate amounts to employees (Box 14, separate statement, etc.)
Ensure your system can distinguish FLSA-required overtime from other overtime types

Before 2026

Update payroll codes to separately track the overtime premium portion (the "half" of time-and-a-half)
Configure time-tracking systems to isolate FLSA overtime premium from base pay
Identify tipped employees and their occupations; map to Treasury Tipped Occupation Codes
Separate voluntary tips from service charges in your payroll records
Test W-2 generation to ensure new fields populate correctly
Train HR and payroll staff on the new requirements

Calculation Considerations

For employees with multiple pay rates, shift differentials, or nondiscretionary bonuses, the "regular rate" calculation under FLSA gets complex. The overtime premium must be calculated based on the correct FLSA regular rate—not just the employee's base hourly rate.

If you offer more generous overtime pay than FLSA requires (e.g., double-time), you'll need to track what FLSA would have required separately. Only the FLSA-mandated premium portion qualifies.

What Employees Need to Know

Employees will claim these deductions on their personal tax returns using the new Schedule 1-A. Key points to communicate:

No withholding changes: Employers should not reduce tax withholding for 2025 based on these deductions. Employees who want to adjust withholding should submit a new W-4 with additional deductions on Line 4b.
Employees must calculate their own deduction for 2025 using pay stubs, year-end statements, or whatever information you provide. The IRS allows "reasonable methods" for estimation.
The deduction reduces federal income tax only. Social Security, Medicare, and most state taxes still apply to overtime and tips.
If you don't provide a separate accounting, employees can use one-third of their total overtime pay as an estimate of the qualified premium.

Common Questions

Do I need to change withholding?

No. The IRS confirmed that withholding tables for 2025 remain unchanged. Employees benefit from these deductions when they file their tax returns—not through reduced withholding during the year.

What about state taxes?

These are federal deductions only. State tax treatment varies. Some states may not conform to the federal provisions, meaning overtime and tips may still be fully taxable at the state level.

What if my payroll system can't track this?

For 2025, use a "reasonable method" to estimate and document your approach. Contact your payroll vendor about updates for 2026 compliance. Most major payroll systems are working on updates to handle the new reporting requirements.

Are independent contractors eligible?

For tips: Yes, if they work in a qualifying tipped occupation and report tips on Form 1099 or Form 4137.

For overtime: The IRS has not issued final guidance on whether independent contractors qualify for the overtime deduction. Most guidance focuses on W-2 employees covered by FLSA.

Key Dates

Date	What Happens
January 1, 2025	Deductions become effective (retroactive)
July 4, 2025	OBBBA signed into law
Tax Year 2025	Transition year—no penalties for missing separate reporting
January 2026	File employee W-2s (2025)—voluntary separate reporting
Tax Year 2026	Mandatory separate reporting on W-2s begins
December 31, 2028	Deductions expire (unless extended)

The Bottom Line

The "no tax on overtime" and "no tax on tips" provisions are real tax benefits for eligible employees, but they come with real compliance obligations for employers. Use 2025 to get your systems ready. Starting in 2026, you'll need to separately track and report:

The FLSA overtime premium (not total overtime pay)
Qualified voluntary tips (not service charges)
Employee occupation codes for tipped workers

Start working with your payroll vendor and HR team now. The penalty relief won't last forever, and employees will be counting on accurate reporting to claim their deductions.

This information is current as of January 2026. IRS guidance is still evolving, and final regulations may modify some details. Monitor the IRS OBBBA provisions page at irs.gov for updates.

Related Resources: