Overtime & Tips: How to Process the New Deductions in Payroll
OCTOBER 30, 2025
As we covered in our first blog in our OBBB series, one of the biggest shifts under OBBB is that certain overtime and tip income becomes deductible, meaning less taxable income for your employees. But that introduces payroll complexity. Here’s how to handle it.
How the Deduction Works (Basics)
- Overtime pay: Up to $12,500 of overtime income may be deductible for single filers (or up to $25,000 for married filers) if they qualify.
- Tips: Up to $25,000 in tips may be deductible (subject to income thresholds) for qualifying employees.
- These deductions are from taxable income, not from wages paid. That means payroll must still withhold (initially) and adjust during tax filing.
- Income phaseouts: The deduction phases out for higher-income taxpayers (e.g. > $150,000 single / > $300,000 joint).
Steps & Best Practices for Payroll Teams
- Separate tracking – Add dedicated fields (or software flags) for “qualified overtime pay” and “qualified tips” so they’re distinguished from regular wages.
- Reporting changes – Ensure W-2 entries, withholding statements, or other reporting forms clearly reflect what portion is “qualified” vs. standard wages.
- Withholding adjustments – Initially, it’s likely safer to withhold as usual (treating full wages as taxable) until updated IRS guidance or payroll system patches come out, to avoid under withholding and potential penalties. (Many providers recommend this cautious approach.)
- Employee communication – Explain to tipped or overtime-eligible staff: the deduction benefit will show up on their tax return, not necessarily in instantaneous take-home pay.
- Retroactive data – Because the deduction is retroactive to January 1, 2025, your system may need to accept retroactive inputs (Jan–Jun 2025) and label those amounts properly so they don’t disrupt filing.
Common Pitfalls to Avoid
- Misclassifying which roles are “customarily tipped” or “eligible overtime” – if categorized incorrectly, deductions may be disallowed.
- Under withholding: if you reduce deductions prematurely without IRS guidance, employees may end up owing at tax time.
- Failing to test payroll runs or previews once vendor updates are available.
- Not understanding the impacts and affects for charitable nonprofits and communities
In our next and final OBBB blog, we’ll cover how the new employer credits and benefit changes under OBBB (childcare credit, paid leave credit, etc.) may help reduce your overall tax burden, and how to integrate them into your payroll/HR strategy.
Contact Payroll Vault at (303) 806-0276 with any questions you may have about the One Big Beautiful Bill for your small business at this time.
