Do you or someone in your family work in a job where tips are customarily received? If so, there’s a new federal income tax break to know about.
Strategy: Claim the new deduction for qualified tip income on your 2025 federal income tax return. The One Beautiful Bill Act (OBBBA) authorizes this special deduction, beginning with tax year 2025. But Uncle Sam’s generosity towards tipped employees won’t last long. This new deduction is scheduled to expire after 2028, barring any further action by Congress.
Here’s the whole story: Generally, all forms of compensation constitute taxable income on both the federal and state income tax levels. This includes discretionary or optional tip payments from customers. Like wages and other compensation, tips are taxed under the graduated tax rate structure as ordinary income with a bottom rate of 10% and a top rate of 37%. Some common examples of tips are as follows: • Cash tips received directly from customers • Tips from customers who leave a tip through electronic settlement or payment. This includes a credit card, debit card, gift card or any other electronic payment method • The value of any noncash tips, like tickets or other items of value • Tip amounts received via tip pools, tip splitting or other tip-sharing arrangements. Tips are also subject to federal payroll taxes. Both employees and employers must meet strict reporting requirements relating to the payment and receipt of tips. If the IRS suspects that tips are being paid “under the table,” it may come after the employee or the employer, or both. New law change: The OBBBA creates a federal income tax deduction of up to $25,000 for qualified tips received during the year. The deduction is available whether you claim the standard deduction or you itemize. The tip deduction that would otherwise be allowed (subject to the $25,000 limit) starts to phase out when your modified adjusted gross income (MAGI) exceeds $150,000, or $300,000 if you are a married joint filer. The deduction is phased out by $100 for each $1,000 of MAGI in excess of the applicable phase-out threshold. So, if you’re an unmarried individual, phase-out is complete when MAGI reaches $400,000. If you’re a married joint filer, phase-out is complete when MAGI reaches $550,000. For this purpose, MAGI means your regular AGI from Form 1040 plus certain tax-free offshore income that you probably don’t have. Reality check: Very few folks who earn tip income will be affected by the phase-out rule. Important: The deduction is only available for tips received in occupations where tipping is a common practice. For instance, waiters and bartenders easily qualify, but not physicians or attorneys. The IRS has published a list of eligible occupations that can be viewed at home.treasury.gov/system/files/136/ Tipped-Occupations-Detailed-8-27-2025. pdf. The tip deduction can also be claimed by self-employed individuals and independent contractors who are regularly tipped in the course of their business activities. But the deduction cannot exceed their business income reduced by other related deductions. Many self-employed workers in the “gig economy,” such as Uber drivers or DoorDash delivery people, will be eligible for the tip deduction. Finally, the OBBBA expands a special employer credit for federal payroll taxes paid on tips. Previously, the credit only applied to tips to workers in the food and beverage industries, but the new law permits it for tips paid to workers providing services like hair and nail care and spa treatments.