Beginning in tax year 2025, a new federal tax policy will allow millions of hourly workers to deduct a portion of their overtime pay and cash tips from their taxable income — potentially reducing their annual tax bills by thousands of dollars. As part of broader changes aimed at easing the tax burden on working-class Americans, these provisions represent a significant shift in how labor earnings are treated under the U.S. tax code.
Here’s a closer look at how the deductions will work, who will benefit, and what employers and workers should know ahead of implementation.
Overview of the Deductions
The following new above-the-line deductions will become available for eligible taxpayers starting in 2025 and continuing through the 2028 tax year:
- Qualified tip deduction: Up to $25,000 per tax return in qualified cash tips can be deducted from gross income. This includes cash handed directly to workers, as well as tips received via credit card and digital payment platforms such as PayPal, Venmo and similar services.
- Qualified overtime compensation deduction: Workers may deduct the “premium” portion of their overtime compensation — defined as the amount paid above their standard hourly rate. For example, if an employee earns $20 per hour and their overtime rate is $30 per hour (time and a half), the “qualified overtime” would be the $10 premium per hour, not the full $30. The deduction is capped at $12,500 for single filers and $25,000 for joint filers.
Neither the qualified tip deduction nor the qualified overtime compensation deduction are available for married taxpayers not filing jointly with their spouse. For all other taxpayers, this deduction will be available without itemizing.
Eligibility and Phase-Outs
These deductions are targeted specifically at lower- and middle-income workers. The benefit begins to phase out for taxpayers with a modified adjusted gross income above $150,000 (single) or $300,000 (married filing jointly). For many hourly employees, this threshold ensures full eligibility.
Further IRS and Treasury guidance is expected to clarify exactly which industries and job roles will qualify under the “customarily tipped” definition.
Implications for Payroll and Withholding
Although the deductions were implemented retroactively to be effective beginning Jan. 1, 2025, workers may not experience any immediate reduction in withholding. As we’re well into the effective tax year, tax has already been withheld on tip or overtime income that may ultimately not be taxable. For some, the full benefit will be realized only upon filing 2025 tax returns in early 2026.
For tax year 2025, employers and other payors must file information returns and furnish statements to taxpayers showing certain cash tips received and the occupation of the tip recipient. In addition, employers must also furnish information to taxpayers regarding qualified overtime pay. Of important note to employers is that the implementation of these new deductions will not limit the ability of employers to deduct payroll tax expense.
While the IRS is likely to provide guidance on W-2 reporting adjustments or new informational requirements related to qualifying tip income and overtime premiums, transitional relief will be available to taxpayers and employers for 2025.
State Tax Treatment Still Uncertain
The new deductions apply at the federal level only. It will be up to individual states to determine whether to conform to these changes in their own tax codes. As with other federal deductions, this could result in a mismatch between federal and state taxable income, depending on where a taxpayer resides.
Strategic Considerations for Employers and Tax Preparers
Employers with large hourly workforces should begin preparing now for potential impacts on year-end documentation and employee communications. Similarly, tax professionals will want to ensure clients understand how to track and document tip and overtime earnings to maximize their deductions.
It may also be prudent to explore internal payroll system updates that enable easier tracking of eligible earnings categories — particularly as IRS regulations take shape.
A Meaningful Shift in Tax Policy for the Hourly Workforce
These deductions mark a rare and targeted change in federal tax policy aimed specifically at wage earners in service and shift-based industries. By excluding portions of tips and overtime from taxable income, the federal government is acknowledging both the volatility and the financial burden associated with non-standard earnings.
For many workers, the result could be a larger tax refund and a fairer reflection of their true earning power — especially those who rely on variable income streams and extended work hours to make ends meet.
While much remains to be clarified about how these provisions will be implemented, the intent is clear: to deliver meaningful tax relief to hourly workers who often bear a disproportionate tax burden relative to their base pay. Employers, accountants and workers alike should watch closely for upcoming regulatory guidance. In the meantime, the best preparation includes good recordkeeping, internal system updates and ongoing communication about how this policy shift might impact your situation.