14 Jul Understanding the New Federal Tax Law on Tips and Overtime: What Employers Need to Know and How to Prepare
Understanding the New Federal Tax Law on Tips and Overtime:
What Employers Need to Know and How to Prepare
The federal income tax exemption for tips and overtime pay—part of the “One Big Beautiful Bill Act” passed on July 3, 2025—is not just a policy change; it’s a payroll mandate. Because it directly affects federal income tax withholding, compliance with this law falls squarely within the payroll function. Unlike many workplace laws that primarily place the burden on the employer, this change will be highly visible to employees as well. News coverage has already popularized the idea that workers won’t owe federal tax on their overtime or tips, and many employees are likely to ask their employers about it immediately.
Although the IRS and Treasury Department have not yet issued detailed implementation guidance, employers must be prepared to answer questions and begin planning. This article outlines the details of the new law, what it means for employers from both a compliance and workforce planning standpoint, and how organizations can begin preparing now.
What the Law Does
Effective for wages earned on or after January 1, 2025, and before January 1, 2029, the new law exempts qualifying tip and overtime pay from federal income tax for eligible workers. The key provisions include:
- Overtime pay: Up to $12,500 of overtime wages per employee per year is exempt from federal income tax.
- Tip income: Up to $25,000 in tips annually per employee is also exempt from federal income tax.
- These limits are expected to be indexed for inflation beginning in 2026.
- The tax exemption applies only to federal income tax. Employers must still withhold and remit Social Security and Medicare (FICA) taxes as normal.
- State income tax treatment will vary depending on whether individual states choose to conform to the federal approach.
This provision is intended to put more money directly into the hands of hourly and tipped workers. But it also introduces a new layer of complexity for employers, especially those with workforces in hospitality, food service, healthcare, retail, and other industries where tipping and overtime are common.
What to Tell Employees Asking About the New Law
- Acknowledge the Law and the Timeline: Yes, the law has passed, and it will ultimately exempt qualifying tip and overtime income from federal income tax. However, payroll systems cannot implement those changes until the IRS releases new withholding instructions, likely in late 2025. Until then, employers must continue withholding federal income tax as they always have.
- Reassure Employees About the Benefit: Even if the exemption isn’t reflected in their paychecks yet, eligible employees are still likely to benefit. The exemption applies retroactively to wages earned starting January 1 2025, so employees may see refunds or reduced tax bills when they file their 2025 tax returns next year.
- Explain Payroll Compliance Requirements: Federal payroll systems are legally bound to follow IRS regulations. Employers cannot stop withholding federal income tax on any portion of wages—no matter what the headlines say—until official rules are in place.
- Prepare Managers with a Talking Point: Equip frontline supervisors with simple messaging, such as:
- “The law is real, and we’re working with our payroll provider to stay compliant. As soon as the IRS gives us the green light, we’ll update the system. You’ll still get the tax benefit when you file your taxes.”
- Maintain a Log of Inquiries: Track employee questions and concerns internally. This can help with communication planning, identify recurring confusion, and demonstrate good-faith effort if questions arise during audits.
What This Means for Employers
While the law is already in effect for 2025 wages, employers are not required to immediately change how they calculate or withhold federal income tax on qualifying compensation. The law includes a transition rule allowing employers to use reasonable estimates when reporting exempt amounts for 2025.
More specifically:
- Employers may continue using current IRS withholding tables for now.
- No W-4 changes are required at this time.
- Qualifying tip and overtime amounts may be estimated using a reasonable method for 2025 year-end reporting.
- The Treasury Department is expected to publish updated withholding tables and formal compliance requirements by the end of 2025, with mandatory implementation starting in 2026.
Until then, employers should focus on preparing their internal systems and processes while monitoring developments from the IRS.
How Employers Should Prepare
- Identify Impacted Employee Groups: Review your workforce to determine who is earning tips, working overtime, or doing both. Employers in service-based industries should pay particular attention.
- Upgrade Time and Tip Tracking Infrastructure: You’ll need a clear separation of regular pay, overtime pay, and tip income. Payroll and time-keeping systems should be configured to capture and flag these categories accurately.
- Prepare for Enhanced Year-End Reporting: Some industry experts anticipate that employers may be required to report exempt tip and overtime compensation separately on the 2025 W-2, even if those amounts are estimated. While the IRS has not yet issued official W-2 instructions for 2025, employers should expect that some form of breakout may be required and plan accordingly. Under any circumstances, it is wise to begin tracking this information now. Regardless of how it must ultimately be reported, it is reasonable to expect that employers will need accurate records of tax-exempt tip and overtime wages to remain compliant and support any potential reconciliation or audit.
- Review Payroll Tax Workflows: Ensure your payroll operations can handle logic that excludes specific pay types from federal income tax while still including them in FICA tax and benefit calculations. This will require coordination between payroll, tax, and finance teams.
- Assign Internal Oversight and Educate Stakeholders: Designate a person or team to monitor IRS guidance, industry updates, and state-level developments. Even though enforcement won’t fully begin until 2026, proactive tracking will help avoid last-minute surprises. At the same time, internal stakeholders—especially in Finance, HR, Legal, and Compliance—should be briefed on how the new rules may affect compensation strategies, payroll operations, and tax administration. It’s also important to include front-line managers where tipping and scheduling are involved so they can respond accurately to employee questions.
- Reassess Compensation Policies and Labor Strategy: Tax-exempt status may affect how workers view overtime and tips. Employers may see changes in employee scheduling preferences, voluntary overtime participation, or even retention strategies. Some employees may attempt to maximize tip or overtime earnings as a result, which could alter shift availability, job bidding, or perceived equity across teams. While adapting to employee interest is important, employers must continue to comply with the Fair Labor Standards Act (FLSA), which governs how jobs are classified and how tip income and overtime are calculated. Use this opportunity to assess how labor is structured and compensated while ensuring policies remain compliant with wage and hour regulations.
- Evaluate Impact on Benefit Calculations: If your organization calculates retirement plan contributions, health-insurance premiums, or bonuses based on taxable income, you’ll need to evaluate how exempting tips and overtime may affect those formulas.
- Consider Multistate Complexity: Because state income-tax rules may diverge, employers operating in multiple states should prepare for inconsistent treatment and begin mapping out how to handle reporting for each jurisdiction.
- Document Your Transition Process: Maintain internal documentation of how you are preparing, estimating, and reporting exempt income during the 2025 transition year. This will support audit readiness and minimize risk in the event of IRS or state inquiries.
Payroll Partners’ Role
The new law introduces substantial complexity to payroll-tax compliance, especially for employers with large hourly workforces. While final IRS guidance has yet to be released, Payroll Partners is actively monitoring the regulatory landscape and preparing our systems and client processes accordingly.
Our compliance, product, and service teams are fully engaged in assessing system updates and developing workflows aligned with anticipated requirements. We are committed to ensuring that our clients’ payroll, tax, and HR operations are supported through every stage of implementation—from planning and transition through full compliance in 2026.
We understand that employers need stability, clarity, and support during periods of regulatory change. Our priority is to ensure you have confidence in your systems, your compliance posture, and your ability to support your workforce.
Payroll Partners will continue to provide timely guidance, product updates, and communication as regulatory agencies issue additional clarification.
Consider an HR Compliance Assessment
Before implementing any system-level or operational changes in response to the new tax law, it’s essential for employers to ensure that their workforce classifications, pay practices, and scheduling policies are fully compliant with existing labor regulations—particularly the Fair Labor Standards Act (FLSA).
A free HR compliance assessment is a smart starting point for any business. It can help confirm whether employees are properly classified as exempt or non-exempt, ensure that tip-reporting policies are valid, and verify that overtime calculations meet federal and state requirements.
If foundational compliance issues are left unresolved, applying new payroll policies based on the recent law could lead to increased risk—including misclassification penalties, wage disputes, or exposure in an audit. Getting the fundamentals right first sets the stage for confident, compliant implementation.
This information is provided with the understanding that Payroll Partners is not rendering legal, human resources, or other professional advice or service. Professional advice on specific issues should be sought from a lawyer, HR consultant or other professional.