New IRS rules on overtime and tips could complicate 2025 tax returns

Brand new rules for tax breaks on overtime and tip income are bound to drive taxpayers bonkers when trying to file their 2025 federal income tax returns next year.

Expect to face far more work and confusion when trying to figure out what income can — and cannot — be deducted for qualifying tips or overtime pay on 2025 federal income tax returns.

Sure, it sounds simple to hear phrases like “no tax on tips” and “no tax on overtime.” But many people will be shocked when they discover the intricate rules — and lack of supporting paperwork — when filing their 2025 federal income tax returns early next year.

One thing is clear: Not every dollar in overtime pay will qualify for a tax break. And not every dollar picked up in tips will get a tax break, either.

The Department of Treasury and the Internal Revenue Service issued some key guidance on Nov. 21 for upcoming tax rules relating to what many still call “no tax on tips” and “no tax on overtime.”

The latest guidance included seven possible scenarios involving tips and overtime. And, the guidance, honestly, didn’t cover every situation — including offering an example for when some overtime doesn’t qualify for a tax break on your 2025 federal income tax return.

Yet, the information released, Friday Nov. 21, offers a glimpse into how much extra work taxpayers will need to do on their own to claim these deductions.

“The guidance confirms that 2025 will be messy and that final regs will likely tighten the rules later,” said Tom O’Saben, enrolled agent and director of tax content and government relations for the National Association of Tax Professionals.

Many people are going to need to review their own records and run their own numbers to determine what to claim as a deduction for overtime pay.

“It could become confusing quickly if employers are unable to provide accurate overtime breakdowns, especially for early 2025,” said Matt Hetherwick, chief program officer for the nonprofit Accounting Aid Society in Detroit.

His advice: Start gathering those pay stubs for 2025 now. Tax filers who don’t receive complete information from their employers will need to review their pay stubs and calendars and create a simple log showing the days and hours they worked overtime.

While it’s late in the year, it doesn’t hurt to begin keeping simple logs now, both for overtime hours and tip income.

“Good records will make filing easier and serve as supporting documentation if the IRS requests additional information later,” Hetherwick said.

The 2025 filing season will come with risks, he said, for taxpayers who don’t maintain adequate records.

“Without logs or supporting documents, they may be vulnerable to an IRS audit or the disallowance of the deductions.”

For 2025 only, employers will not be required to break out what overtime pay qualifies for the tax break and what overtime pay doesn’t.

Beginning with 2026, employers will have to break out qualified overtime compensation as a separate line item by law. And tax filers will be able to refer to that paperwork when completing their 2026 returns in 2027.

“But taxpayers get no such help for 2025, which is why 2025 will be challenging,” O’Saben said.

The tax breaks for tips and overtime — which were part of the One Big Beautiful Bill Act signed into law July 4 — are retroactive to Jan. 1 for 2025 tax returns. But few employers, if any, will go back and retroactively reconstruct your tip or overtime income, O’Saben predicted.

The simplest point to understand: It won’t matter if you itemize all deductions or claim the standard deduction, as most people do.

The deductions for tip income and overtime will apply to both itemizers, as well as non-itemizers. And they will be treated as a below-the-line deduction that will be subtracted after your adjusted gross income has been determined. It will not reduce your AGI and not help you tap into some credits or other tax breaks.

Let’s look at overtime pay first.

As I reported earlier, taxpayers won’t be able to deduct all the overtime pay they received when they picked up extra hours in 2025.

IRS Notice 2025-69 issued Nov. 21 makes it clear that qualified overtime is only the amount of money you receive that covers the “half” portion of the “one and one-half times” your pay for overtime, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting in Riverwoods, Illinois.

Say you’re paid $10 an hour at regular time. But you’re paid an extra $5 an hour — half your regular rate — when working overtime. You only get to deduct that $5, not the entire $15 an hour earned during those overtime hours.

The twist many tax filers likely won’t realize upfront: Workers are not able to claim all the extra money they’re paid when they work overtime hours.

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In its guidance issued Nov. 21, the IRS outlined one example for a taxpayer called “Andrew” who receives a payroll statement from his employer that shows $5,000 as the “overtime premium” that he was paid during 2025.

In this example, it’s fairly simple.

Andrew may include $5,000 — the Fair Labor Standards Act overtime premium — to determine the amount of qualified overtime compensation eligible for a tax deduction in tax year 2025.

The premium is the amount that exceeds your regular rate of pay for those overtime hours worked.

Here’s a less-straightforward scenario: Say Andrew’s payroll statement doesn’t show the overtime premium. Remember, it is likely that many employers will not break out that number for 2025.

Instead, Andrew finds himself at tax time looking at a total “overtime” amount of $15,000 —which is all the money Andrew was paid for working overtime during 2025. The overtime premium ends up in this example being combined with the portion of his regular wages.

In this example, Andrew’s overtime premium under the Fair Labor Standards Act remains at $5,000.

In this example, the IRS noted, Andrew may compute the overtime premium by dividing $15,000 by three to calculate the amount of qualified overtime compensation that could apply to the tax break for 2025.

What if you’re paid “double-time” for overtime? Doesn’t matter when it comes to the tax deduction. You’d still only get a tax break on that half portion of your regular pay.

The IRS gives another overtime-related example for “Brad” who is paid two times his regular pay when working overtime.

In Brad’s case, he’s going to need to divide that overtime pay by 4 to calculate the correct answer for his tax return, if his employer doesn’t break out the amount of qualified overtime compensation for him.

Say Brad’s last pay stub for 2025 shows “overtime” of $20,000 paid in 2025. The IRS notes that Brad can only claim $5,000 in this example — the overtime premium. You’d take that $20,000 divided by 4 to get there.

For 2025 only, employers will not need to spell out the overtime premium separately, O’Saben noted, and few if any will go back and retroactively reconstruct it.

“That means workers must determine their ‘qualified overtime compensation’ using pay stubs, year-end earnings summaries, or their own hours records, applying one of the complicated ‘reasonable methods’ in (IRS) Notice 2025-69,” O’Saben said.

Of course, most taxpayers have never calculated the overtime premium in the past.

“Many don’t understand the concept of ‘regular rate,’ nondiscretionary bonuses, or blended pay rates,” O’Saben said.

Tax professionals, he added, will be sorting through pay documentation that varies widely by employer.

A new, two-page, federal income tax form called Schedule 1-A will need to be completed when filing your 2025 federal income tax return to claim the new deduction for overtime pay, as well as new deductions for tip income, car loan interest, and a new tax break for those 65 and older.

The maximum annual deduction for overtime pay on your 2025 federal income tax return is $12,500 for single filers and $25,000 for those who are married filing a joint return.

The deduction phases out for taxpayers with modified adjusted gross income that exceeds $150,000 for singles and $300,000 for joint filers.

In some cases, tax filers will not be eligible to deduct any overtime.

Some employees are exempt from federal overtime rules, including those in executive positions, administrative jobs, professional fields, and many who work in sales and receive commissions. In these cases and others, O’Saben noted, any extra pay these employees receive for long hours is not required under the Fair Labor Standards Act so none qualifies for a tax break.

“Notice 2025-69 flags this explicitly: Overtime paid to FLSA-ineligible employees is not qualified overtime” when it comes to the new tax break, he said. That’s true regardless of whether the employee was paid overtime under state law or other circumstances.

O’Saben pointed out that other situations that won’t qualify for the new federal income tax deduction, including shift differentials for night or weekend work, hazard pay, on-call premiums and holiday pay premiums.

It’s going to get complicated, and perhaps frustrating, for people who will need to take time to understand how they’re paid and what tax rules apply to their situation.

“The biggest takeaway is how much responsibility the IRS is shifting to taxpayers for the 2025 year,” O’Saben said.

The IRS explicitly acknowledges, he said, that the forms that employees receive regarding wages won’t match the law yet.

“The IRS is giving taxpayers multiple ways to reconstruct 2025 tip and overtime amounts, effectively admitting that the system isn’t ready,” O’Saben said.

The new, special tax deductions on overtime and tip income are retroactive and apply to eligible income earned in all of 2025 — going back to Jan. 1.

Employers likely didn’t update their systems for recording overtime and tip income early in the year with expectations of the new tax rules that rolled out in the summer. So, we’re talking about a transitional tax year when people file 2025 income tax returns in 2026.

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Now, consider how detailed tax rules will apply to tip income.

“Reporting tip income for 2025 will be as confusing or even more confusing than reporting overtime,” Luscombe said.

People who work as employees of a company, as well as gig workers or nonemployees, will have to choose among the options available, as detailed by the IRS, Luscombe said.

They will also need to determine whether they work in one of nearly 70 separate occupations of tipped workers, from bartenders to water taxi operators, that qualify for a tax deduction for tip income, based on IRS guidance.

The IRS said it is estimated that there are about 6 million workers who report tipped wages.

Yet, the paperwork tax filers receive could be lacking information they need. For example, Form 1099-K, which is issued to gig workers, does not separately identify the tips.

As a result, O’Saben said, taxpayers and tax professionals will need to check for information on a variety of spots — Box 7 on the W-2 that shows tips that are subject to Social Security and Medicare taxes, monthly Forms 4070 where employees report their tip income to employers, Box 14 on a W-2 entries if employers choose to show tips, Form 4137 for unreported tips, daily tip books and more.

“Many tipped workers don’t keep consistent tip logs, and gig economy platforms may not separate tip amounts in a way that meets IRS standards,” O’Saben warned.

“Preparers will be piecing this together from whatever documentation exists,” O’Saben said.

The IRS guidance issued Nov. 21 offered an example for “Ann,” a restaurant server. According to the IRS example, Ann has $18,000 of Social Security tips reported in box 7 of her Form W-2 for 2025. Ann did not report any additional tips on Form 4137.

Ann, according to this IRS example, may use $18,000 in determining the amount of her qualified tips for tax year 2025.

Another example involves bartender Bob.

Bob reported $20,000 in tips to his employer during the 2025 tax year on Forms 4070 and reported $4,000 of unreported tips on Form 4137, line 4.

The IRS stated: “Bob’s 2025 Form W-2 reports $200,000 in box 1 (for all wages, tips, other compensation) and $15,000 in box 7 (Social Security tips),” according to the IRS guidance.

“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.”

And regardless of the option chosen, the IRS said, Bob may also include the $4,000 of unreported tips from Form 4137, line 4 in determining the amount of qualified tips.

Oh, it will get increasingly complicated for some workers who receive tip income.

Take “Doug,” the IRS example for someone working as a self-employed travel guide.

In 2025, Doug received $7,000 in tips from customers paid through a third-party settlement organization.

For tax year 2025, according to the IRS example, Doug receives a Form 1099-K from the third-party settlement organization showing $55,000 of total payments.

The Form 1099-K does not separately identify the tips. So, Doug needs to do that on his own.

In this example, 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,” the IRS stated.

The IRS and Treasury issued guidance in September that outlined the occupations that will qualify for the so-called “no tax on tips” deduction.

Jobs on that list included: Blackjack dealers at the casino, plumbers, club dancers, washing machine installers, tow truck drivers, tattoo artists, taxi and rideshare drivers, math tutors, yoga instructors, golf caddies, airport shuttle drivers and more.

Another quirk: Under the One Big Beautiful Bill Act, an employee of what’s deemed a Specified Service Trade or Business is not entitled to the tips deduction.

These specified areas, Luscombe said, include professional businesses such as accounting, law, medicine, performing arts, consulting and athletics. It’s basically any trade or business, he said, where the principal asset of the business is the reputation or skill of one or more employees or owners of the business.

But Notice 2025-69 indicates, Luscombe said, that it may be difficult for some employees to know if they are in a Specified Service Trade or Business.

Therefore, Notice 2025-69 provides that it is OK to claim the tips deduction for 2025 even if a taxpayer is in fact an employee of an Specified Service Trade or Business if they also are in an occupation that customarily and regularly received tips before Dec. 31, 2024.

The new law stipulates that the maximum annual deduction for tip income is $25,000 per tax return — not $25,000 for each employee listed on a joint return. The deduction for tips also phases out for taxpayers with modified adjusted gross income over $150,000 and $300,000 for joint filers.

The IRS takes the position that a tip must be voluntary, not required by the employer or establishment, paid freely by the customer and given directly or indirectly to the worker to qualify for the tax break.

The IRS specifically states that qualified tips do not include some service charges, including when a restaurant imposes an automatic 18% service charge for large parties.

Many times, the restaurant will distribute that amount to waiters, the kitchen staff and others. But the IRS said if the charge is added with no option for the customer to disregard or modify it, the amounts distributed to the workers in this case are not qualified tips and cannot be eligible for the tax break.

No doubt, the tax breaks could lead to bigger tax refunds for many people next year after they file their 2025 federal income tax returns. But you’re going to want to make sure to take the extra time necessary to claim the right deductions.

Contact personal finance columnist Susan Tompor: stompor@freepress.com. Follow her on X @tompor.

This article originally appeared on Detroit Free Press: How ‘no tax’ on overtime and tips could trigger tax headaches