How to Prepare Payroll for 2025 Tip & Overtime Tax Deductions

The One Big Beautiful Bill Act (OBBBA) brought in two new payroll-related deductions for 2025. They could be a real benefit for employees—but only if payroll is set up to support them.

If your employees want to claim the “no tax on tips and overtime” deductions on their 2025 tax return, the groundwork starts now. These deductions depend on how tips and overtime premium pay are coded in payroll and how they show up on the W-2.

Let’s break down what’s changing, what you’ll need to track, and how to get ready before year-end.

New Tip and Overtime Tax Deductions for 2025

The bill adds two new federal income tax deductions for employees:

• Up to $25,000 in tip income
• Up to $12,500 in overtime premium pay (or $25,000 if married filing jointly)

These aren’t instant paycheck changes. Employees will claim them when they file their 2025 tax return in early 2026. Until then, nothing changes on the W-4, and you won’t see the impact in payroll withholding.

Employer Payroll Responsibilities Under the One Big Beautiful Bill Act

For these deductions to work, W-2s have to be accurate. That means the way you code pay types—right now—will determine whether employees can claim the benefit later.

What to check in your payroll setup this year:

• Make sure tips are recorded in the correct payroll field so they flow to the right W-2 box (Social Security tips, Box 7).

• Use a standard “overtime” pay type—don’t blend it with holiday pay, bonuses, or custom categories.

You don’t have to decide who qualifies or calculate the deduction yourself. Your job is to keep payroll records clean so eligible employees can claim it later.

Learn more about why many small businesses choose to work with a payroll service in our article Why Small Businesses Need Payroll Services.

Who Qualifies for the Tip Income Deduction?

The IRS hasn’t released its official list of qualifying occupations yet, but current guidance suggests it will likely apply to jobs where tips are a regular and significant part of earnings.

“Gray area” roles—where tipping is rare or inconsistent—may not make the cut.

Until the IRS issues formal guidance, leave W-4s as they are. Employees can still claim the deduction on the 1040 at tax time if they qualify.

It's also worth noting that this deduction won’t help everyone equally. A part-time teen earning less than the standard deduction won’t see much change. High earners might not either. In most cases, the biggest benefit will go to those in the middle—earning enough to owe tax, but not so much that the deduction barely moves the needle.

Overtime Premium Deduction Rules and Limits for 2025

• This deduction covers only the overtime premium—not total overtime pay.

Let's say an employee earns $20/hour and works 1 hour of overtime at $30/hour.
Only the $10 overtime premium qualifies for the deduction.

• Total worked hours must be over 40 in a workweek under federal law.

If an employee works 10 hours on Monday and receives 2 hours of overtime pay—but doesn’t work again that week—those overtime hours won’t qualify. They qualify only if the total hours for the week exceed 40.

• Daily overtime, union double-time, and state-specific rules (like California’s after-8-hours rule) don’t qualify.

How Employers Should Prepare Payroll for 2025 Deductions

2025 is a transition year. The IRS hasn’t updated forms or tax tables yet, but that doesn’t mean you can’t get ahead of it.

Here’s where to start:

 Review how you’re coding tips and overtime
  Standardize overtime into one clean earnings category
 Keep custom pay types and bonuses separate from overtime
 Check that reported tips flow correctly to W-2 Box 7
  Watch for IRS guidance this fall—especially if you run payroll in-house

Everything you record this year will drive what’s on the W-2 in January. That’s why it pays to get it right now.

Why Accurate Payroll Records Matter for the 2025 Deductions

Some employees already expect these new deductions to show up in their paychecks. That’s not how this works. The benefit comes at tax time—and only if the payroll records are clean. An error in your payroll data flows straight to the W-2, and the employee may lose out on the deduction entirely.

Final W-2s for 2025 go out by January 31, 2026. Every paycheck you run this year builds the data for those forms. Once the year is over, there’s no easy way to fix large reporting gaps without issuing corrected forms—and that can mean extra work for you and delays for the employee.

The cleaner your records are now, the smoother year-end will be—and the better chance your employees have to claim the full deduction.

Get Payroll Help Navigating the New 2025 Deduction Rules

If you already run payroll with us, we’ll keep you updated as the IRS releases guidance and make sure your year-end reporting is ready.

Not sure if your payroll setup is ready for the new rules? Schedule a call to see how having a dedicated payroll specialist—someone who knows your business—can make it easier to pay your team and stay compliant.

Your Payroll Department (YPD) is part of the Kaizen CPAs family. Together, we deliver accounting, advisory, tax planning, and payroll services—helping businesses save on taxes, stay compliant, and free up time to focus on growth.