Even though the Trump administration is promoting larger tax refunds this year, it’s possible that some Americans could find themselves facing higher tax bills once the new tax law kicks in.
“One major concern with the new overtime and tip deductions is the heavy reliance on self-reporting,” noted Alex Bean, a financial literacy lecturer at the University of Tennessee at Martin. “If there’s no standardized way for employers to verify eligible overtime and tip income, the responsibility falls on the employee to figure it out.”
“This opens the door for mistakes, and a return filled with errors could result in an IRS notice,” he added.
Why is it important
This week, the Treasury Department revealed that President Trump’s tax cuts for working families are projected to boost average tax refunds by $1,000 per household.
However, depending on how specific rules—like the tax exemption on tips—apply to your situation, you might end up with a bigger tax bill than anticipated.
What you need to know
The Trump administration has introduced significant tax reforms that change what Americans owe, and in some cases, increase their tax refunds.
Over 100 million households are expected to receive refunds, thanks in part to an enhanced child tax credit that could lead to an average tax reduction of $1,700 for families with two children.
The child tax credit for the 2025 tax year has been raised to $2,200, adjusted for inflation, and the standard deduction has been doubled, impacting about 90% of U.S. taxpayers, as stated by the Treasury Department.
Yet, some Americans may see higher tax bills if the IRS audits them and uncovers inaccuracies linked to these new regulations.
Explanation of why tips are not taxed
Beginning with the 2025 tax year (returns submitted in 2026), the “Tip Tax Exemption Act” introduces a federal deduction for qualified tip income.
This allows individuals to deduct up to $25,000 of their tip income from their federal taxable income.
Deductions reduce the amount of income subject to federal tax, resulting in lower federal tax bills. Notably, these deductions apply whether utilizing the standard or itemized deduction.
But, it’s not as straightforward as it seems.
“While it might sound simple to claim that ‘tips are not taxable,’ the reality can catch taxpayers off guard,” explained Alex Bean. “For workers, FICA taxes will be taken from their paychecks throughout the year, even if their income tax liability is lower at the time of their tax return. Consequently, some individuals might receive a smaller refund than they anticipated.”
When did tip tax exemption start?
Although it was signed into law last July, the tip deduction is retroactive to tips earned from January 1, 2025.
This means that you can claim it on your 2025 tax return this year. The deduction is applicable for tax years from 2025 until 2028, unless Congress extends it.
Financial experts caution taxpayers against reporting cash tips without proper documentation.
“You should report on W-2 Box 7, but if you’re providing monthly reports or your employer is nice enough to include cash tips in Box 14, you’re probably using Form 4070. However, a lot of people may look at that figure and think, ‘Oh, I made much more in unreported cash tips’ and then add that in,” said Michael Ryan.
“Avoid doing that. If those tips aren’t reflected on your W-2 or Form 4137 and you acknowledge them, you’re basically admitting you didn’t report it to your employer. The IRS can retroactively assess FICA taxes and penalties, which isn’t a loophole—it’s an acknowledgment of unpaid taxes.”
No tax is payable on the start date of overtime work
The overtime tax exemption is part of the One Big Beautiful Bill Act, which passed and was signed into law by the president on July 4 last year.
The law is retroactive, applying to overtime earned after January 1, 2025.
This means that qualified overtime earned after this date can be deducted from federal taxable income when filing the 2025 tax return.
Persons eligible for exemption from tax on tips and tax on overtime work
The criteria governing tax exemptions for tips and overtime differ.
The tip exemption applies to voluntary tips from customary tipping occupations and is reported on Form W-2, 1099-NEC, 1099-MISC, 1099-K, or Form 4137.
Eligible roles include servers, bartenders, delivery drivers, spa workers, and some gig workers.
The overtime tax exemption, however, is mandated under the Fair Labor Standards Act (FLSA) and pertains to those receiving overtime pay documented on Form W-2 or 1099 (and other prescribed forms).
Income limits start to phase out at $150,000 for single filers and $300,000 for those filing jointly.
A system that avoids tax on overtime work
The provision for overtime work doesn’t completely remove taxes on overtime pay.
Instead, it allows you to deduct a portion of the additional amount earned for overtime hours from federal income taxes.
This law establishes a new deduction for “qualified overtime pay” applicable solely to federal income taxes, while payroll taxes (like Social Security and Medicare) and most state taxes remain unchanged.
People’s opinions
Michael Ryan, a financial expert and the creator of his eponymous firm, expressed surprise that more individuals aren’t expressing dissatisfaction with the situation. He stated, “Employers seem to be getting a pass this year. The IRS is aware that there’s no system in place for separating overtime and tips for 2025 and is essentially saying, ‘Don’t worry about it this year.’ From now on, if things aren’t reported correctly, there will be penalties. But at this moment? Employees are just left to figure it out, which is quite frustrating.”
Alex Bean added, “When tax benefits hinge on employees scrutinizing their pay stubs rather than clear reporting categories, the likelihood of errors skyrockets.”
What happens next
Individuals who misestimate their taxes might face penalties under the new system concerning tips and overtime pay.
“If you overestimate, perhaps believing in the best-case scenario, you may get a correction notice. The IRS will recalculate your actual tax obligation and issue a bill for the difference, plus interest. It’s not ideal, but managing it is possible,” Ryan explained.
“What could go wrong? You might owe over $1,000 in back taxes due to a miscalculation, which would trigger an underpayment penalty. Or, you could incorrectly claim a tip deduction for unreported cash tips, leading the IRS to investigate your FICA taxes. Those rates are 15.3% if self-employed or 7.65% for W-2 employees, and they could be assessed for many prior years, along with penalties.”
He concluded, “This year is incredibly messy. The expectation was for employers to provide estimates in Box 14 or through separate statements to avoid confusion, but many didn’t. Consequently, workers are stuck trying to decipher their pay stubs, figuring out what qualifies as tips or calculating overtime. Honestly, I believe a lot of people are going to make mistakes.”
