Tips

If tips are no longer subject to payroll taxes, should they go into a plan as Roth?

A decision on whether to deferrals should be made pre-tax or Roth should be made based on a complete understanding of personal income and personal preferences.

The new law regarding is much more complicated that one would think.  It creates a Federal deduction for tips that can be taken on a personal income tax form.  It does not exclude tips from all payroll taxes.  The exclusion is solely for Federal income taxes.  Tips are subject to Social Security and Medicare taxes, and any applicable State and Local taxes.

There is a cap of $25,000 on the amount of tips that are deductible, and this phases out as income rises above $150,000 (for single filer) and phases out if income reaches $400,000 (for single filer).

Not all occupations qualify for the tips deduction. The IRS is required to publish a list of occupations eligible for the tips deduction by October 2, 2025.  If you earn tips in an occupation that does not appear on the list (when it is published), you get no tips deduction.

While you are looking at income taxes, also keep in mind that there is a new deduction up to $12,500 (for single filer) available on overtime pay.

NOTE TO PRACTIONERS: The new deductions are effective for income earned starting January 1, 2025.  Payroll does not yet have full guidance on how to report tips and overtime so expect compensation information reported on 2025 census data to be exceptionally vulnerable to errors.

Consider also that some tips paid directly by a customer, not processed through the employer’s payroll, and not W-2-reported by the employer might not count under a particular plan’s definition of compensation for one or more relevant purposes.

Also, if a plan sponsor, thinking about changes regarding tips or overtime, wants to amend a plan, the recent budget-reconciliation act does not set a statute-specific remedial-amendment period.

Actually, I believe no tax on tips only applies to federal income tax, tips are still reportable and subject to FICA and FICA Med taxes. 

So, you need to be careful about how you define covered compensation, and, careful about your payroll processing as well. 

But how, if at all, does an employer tax-report (for any purpose) a cash tip the employer never saw and the employee never reported to her employer?

Some employers estimate unreported-to-the-employer cash tips by extrapolating from records of bank-card tips, but some might not.

And there might be some kinds of employers and employees for whom cash tips are the only kind. (Some businesses don’t accept bank-card payment.)

As always, read carefully the plan’s governing documents for each definition for each measure of compensation.

Consider also that the new Federal law is not an exclusion from gross income; it is a deduction from income in an individual’s tax return. The deduction does not affect any Federal tax law measure of wages, not even Federal income tax wages.