Understanding "Qualified" Tax Exemptions for Tips and Overtime

Nextep blog - tax exemptions for tips and overtime

What counts as “qualified” tips and overtime pay when you’re looking at tax exemptions? We’re here to break it down for you.

One of the changes included in the One Big Beautiful Bill Act (OBBBA), passed in July 2025, introduced a federal tax exemption on “qualified” tips and overtime wages.

This exemption only applies to federal taxes. Unless your state has different provisions, tips and overtime pay are still fully taxable by state and local authorities. They’re also still subject to FICA (Social Security and Medicare) taxes.

Paychecks will still have the usual tax deductions. Your employer will then report those wages on Form W-2. Qualified tips and overtime pay will be exempt from federal taxes when employees file their IRS tax returns.

The word “qualified” presents some ambiguity, however. To address this, the IRS issued Notice 2025-69 with guidance. Here’s a rundown.

Qualified Tips: What Counts and How to Calculate

First, let’s look at tips. For tips to be tax-deductible, they must be “cash tips,” including those given via cash, check, or credit card. Tips must be received while doing one of these jobs that customarily receive tips:

Beverage and food service
Entertainment and events
Hospitality and guest services
Home services
Personal services
Personal appearance and wellness
Recreation and instruction
Transportation and delivery

Qualified tips must be voluntary, at the customer’s discretion. Automatic or negotiated gratuities, service fees, or non-cash tips, such as tickets or gifts, are considered wages (not tips) under OBBBA and are not exempt from federal tax.

Since there will be stringent rules governing how workers earn tips, the IRS is waiving checks and balances for 2025 tipped wages and will assume yours are eligible. Beginning in 2026, they’ll more carefully consider how you earned tips to determine whether they’ll be tax-exempt.

Tip Calculations

Here’s how to calculate which of your tips will be exempt from federal taxes.

In 2025: For your 2025 tax return, you’ll use the total amount of Social Security wages reported in Box 7 of your Form W-2. Alternatively, you can use the total qualified tips you reported to your employer on Forms 4070 or your own daily tip logs.
2026-2028: After 2025, qualified tips will be reported in Box 12 of the W-2 using code “TP.” The employer will report the worker’s specific occupation code in a new Box 14b.
Non-employees: If you are a non-employee (1099), use your receipts, point-of-sale reports, or earnings statements to calculate the total tips received.

Tip Limitations

The federal tax exemption applies only to the worker’s first $25,000 of qualified tips each calendar year.

The tax deduction shrinks for high earners. For every $1,000 you earn above $150,000 ($300,000 if married filing jointly), the maximum allowable deduction is reduced by $100. Your tax deduction disappears altogether if you make more than $400,000 in the year ($550,000 if married filing jointly).

If you’re married, you can only claim the deduction if you file taxes jointly. The law states that those married filing separately cannot claim the tip or overtime tax exemptions.

Qualified Overtime: The “Premium” Rule

Like tips, you can only deduct “qualified” overtime pay. The standards under OBBBA are the same as those in Section 7 of the Fair Labor Standards Act (FLSA). This Act generally refers to the time-and-a-half pay required for hours worked over 40 in a workweek.

When filing your tax return, you can only deduct the “premium” amount of the overtime pay above your regular rate. It would be the “…and-a-half” portion of time-and-a-half. If your employer voluntarily pays you double time, you can still only exempt taxes on the half portion above your regular pay rate.

Overtime Calculations

Here’s how to calculate how much of your overtime pay will be exempt from federal taxes.

In 2025: As a reminder, the employer is only required to make changes to the W-2 after the 2026 tax year. For 2025, you can refer to your final pay stub of 2025 to find overtime pay. Nextep clients: see our FAQ for easy instructions on downloading your pay stubs.
The Divide by 3 Method: If your pay stub shows overtime at the standard time-and-a-half rate, the IRS recommends using the “divide by 3” method to calculate how much of that is tax-exempt. Take the total dollar amount paid for overtime hours in 2025 and divide it by three. The result is your deductible amount.
2026-2028: After 2025, qualified overtime wages will be reported in Box 12 of the W-2 using code “TT.”

Overtime Limitations

You can deduct up to $12,500 in qualified overtime pay for each 2025-2028 tax year.

The overtime deduction shrinks for high earners. For every $1,000 you earn above $150,000 ($300,000 if married filing jointly), the maximum allowable deduction is reduced by $100. Your tax deduction disappears altogether if you make more than $275,000 in the year ($550,000 if married filing jointly).

Remember, you can only deduct the “…and-a-half” portion of overtime pay – not the entire time-and-a-half amount.

If you’re married, you can only claim the deduction if you file taxes jointly. The law states that those married filing separately cannot claim the tip or overtime tax exemptions.

Reminders

Hold on to your pay stubs, tip logs, and any other documentation that substantiates tips or overtime, especially for 2025. You’ll need these documents to verify your claim if the IRS asks for proof.

Questions? We’re here to help! Contact Nextep for guidance.

Read Nextep’s full OBBBA Employers Guide:

OBBBA Employer’s Guide

Additional resources:

IRS official guidance on tips and overtime tax exemptions: Notice 2025-69
OBBBA full text: Congress.gov

Legal Disclaimer

Information regarding the One Big Beautiful Bill (OBBB) is provided for informational purposes only and does not constitute tax or legal advice. Eligibility for deductions, including those referenced in IRS Notice 2025-114, depends on individual circumstances. The information provided herein is subject to revision and may not be the most current information available. Nextep strongly recommends consulting a certified tax advisor to ensure compliance and accuracy. Nextep assumes no liability for eligibility determinations or the receipt of tax credits. See IRS guidance here for more info.

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