Shining Some Light on the Tips Deduction

At the recent Winter Lantern Festival at Jamestown Settlement in Virginia, the grounds were bursting with colorful creations.  The lanterns were anywhere from 6 to 30 feet high and made of hand-painted linen stretched over frames filled with lights.  Many of the lanterns were based on mythology, the zodiac, or other fanciful ideas, but there were some based on common objects.

Among the hundreds of artworks on display were lanterns related to musicians, drivers, servers, and entertainers.  What do these jobs have in common?  They, along with housekeepers, hairdressers, tutors, golf caddies and too many other careers to name, are on the IRS list of occupations that qualify to claim the new “No Tax on Tips” deduction.  (For the official list, see this IRS document.)  Only occupations that “customarily and regularly” received tips before December 31, 2024 qualify for this tax break.

Couples choosing Married Filing Separately filing status are not eligible to take this deduction.  Furthermore, the new tax break is temporary, only being available for tax years 2025 – 2028.  

There is a $25,000 per return limit on the deduction, meaning a single taxpayer and a couple filing jointly are both subject to this cap.  On a single return, the deduction starts to phase out when Modified Adjusted Gross Income (MAGI) exceeds $150,000; on a joint return, the phaseout begins when MAGI goes above $300,000.  The phaseout is $100 for every $1000 that MAGI exceeds the cap, so singles get a reduced benefit from $150,000 - $400,000; joint filers phase out between $300,000 and $550,000.  Incomes above these limits do not qualify for any deduction.

It's important to note that this new law is a break on federal income taxes only.  Social Security and Medicare taxes (FICA taxes) are still due on all tips received.  Likewise, self-employed individuals must still pay self-employment tax on their tip income.  States may still require income tax to be paid on all income, including tips.  At the time of this post, North Carolina will be taxing all tip income.

Tipped employees who reported their income properly will have an amount in Box 7 of their W-2 to substantiate the deduction.  If the employee has unreported tips, Form 4137 can be used to report these amounts, pay FICA taxes, and take the deduction.  Unreported cash tips cannot be deducted.

Self-employed people may deduct qualifying tips that are included in amounts reported on Forms 1099-K, 1099-NEC, or 1099-MISC, even if the tip amounts aren’t separately stated.  However, the taxpayer should have a detailed tip log documenting all amounts deducted.  Just as employees may not deduct unreported cash tips, self-employed workers may not deduct them either.

The IRS estimates that over 6 million Americans regularly receive tips for their work, so this new tax deduction has the potential to benefit a lot of taxpayers.  If you’re one of them and you find yourself with a little extra money because of this new law, consider visiting the Jamestown Winter Lantern Festival next year for a truly magical night!   

Chinese lantern depicting a violin