If you have tipped or overtime-eligible employees, 2026 is the year the new federal tip and overtime deductions show up on the W-2. The One Big Beautiful Bill Act, signed into law on July 4, 2025, created two new federal income tax deductions: one for qualified tips and one for qualified overtime pay. Both deductions have applied since the 2025 tax year, but the IRS gave employers a transition year on reporting them. That transition ends with tax year 2026.
These are federal income tax deductions for employees, not payroll tax exemptions and not a change to how you calculate pay. Employees still owe Social Security and Medicare tax on every dollar of tips and overtime, and depending on the state, state income tax may still apply too. What changes is what an eligible employee can deduct on their own federal return.
Qualified tips. Employees in occupations that customarily and regularly received tips on or before December 31, 2024, can deduct up to $25,000 in qualified tips each year. That cap is $25,000 per return, whether the employee files single or jointly. Qualified tips must be voluntary and paid in cash or a cash equivalent, such as a check, credit card, or debit card. Automatic service charges and mandatory gratuities don't count. Under the final regulations, the customer must also have the option to leave no tip at all. A menu that adds 18% for large parties, or a point-of-sale screen that doesn't let a customer choose zero, produces amounts that are not qualified tips.
Treasury and the IRS finalized the list of qualifying occupations in April 2026. It covers more than 70 occupations in eight categories, and each one is assigned a three-digit Treasury Tipped Occupation Code (TTOC). The list includes the roles you would expect, like servers, bartenders, bussers, and hosts, along with occupations outside food service, such as hairdressers, golf caddies, and taxi drivers.
Qualified overtime. Employees can deduct up to $12,500 a year ($25,000 for joint filers) of the overtime premium, specifically the "half" portion of time and a half required under Section 7 of the Fair Labor Standards Act. This is an important distinction. If overtime is paid under a state law, a union contract, or a company policy that goes beyond what the FLSA requires, that portion does not qualify. Only the federally mandated premium counts.
Both deductions begin to phase out once an employee's modified adjusted gross income passes $150,000 for single filers or $300,000 for joint filers, reduced by $100 for every $1,000 over the threshold. Both are set to expire after the 2028 tax year unless extended.
When the law passed in mid-2025, the IRS acknowledged that employers and payroll providers had no time to build new reporting fields into that year's tax forms. Under Notice 2025-62, the IRS granted transition relief: employers were not penalized for failing to separately report qualified tips or qualified overtime on 2025 Forms W-2 or 1099. A companion notice, Notice 2025-69, explained how employees could figure the deduction for 2025 using their own records.
That relief does not carry into 2026. The final 2026 Form W-2, released in January 2026, adds three new reporting fields for these deductions:
Getting this wrong is not a paperwork footnote. Incorrect or incomplete W-2s are subject to the IRS's standard information return penalties, currently $60 to $680 per form depending on how quickly errors are corrected. These amounts adjust annually for inflation.
Employees may also start asking about their paychecks. The 2026 Form W-4 includes new lines in the Step 4(b) Deductions Worksheet where employees can estimate their qualified tips and qualified overtime. An employee who submits an updated W-4 may see lower federal income tax withholding, although Social Security and Medicare withholding stays the same.
Confirm which overtime is FLSA required. Only the federally mandated premium counts as qualified overtime. If your policies, state law, or a union contract pay overtime more generously than the FLSA requires, your payroll records need to distinguish the two.
Assign occupation codes to tipped roles. Match each tipped position against the final Treasury Tipped Occupation Code list rather than assuming every tip-earning role qualifies. Employees who work two qualifying tipped roles may need two codes.
Review how tips are collected. Make sure point-of-sale tip prompts give customers a zero-tip option, and keep mandatory service charges separate from voluntary tips in your records.
Verify year-to-date totals. 2026 reporting covers everything paid since January 1. If tips, qualified overtime, or occupation codes weren't tracked separately from the start of the year, reconcile year-to-date amounts before your final payroll.
Prepare for the new W-2 fields. Confirm your payroll system can populate Box 12 codes TP and TT and the Box 14b occupation code before year-end filing season.
Keep FICA withholding unchanged. Continue withholding Social Security and Medicare tax on the full amount of tips and overtime. Federal income tax withholding follows the employee's Form W-4, so process any updated W-4s as usual.
Communicate with affected employees. Tipped and overtime-eligible staff will have questions about how this affects their paycheck versus their tax return. Setting expectations early avoids confusion in January. For questions about how to fill out their W-4 or claim the deduction, point employees to the IRS or a tax professional.
New W-2 codes, occupation codes, and the first year of required reporting leave little room for error across a full year of pay periods. Once you've identified which overtime is FLSA required and which roles fall under a qualifying tipped occupation, PayNW processes those amounts each pay period and reports them in the correct W-2 boxes at year-end. Are you ready for this reporting?