What Counts as Tip Income and How It’s Taxed Under the New Law
- Kim Yurosko
- Nov 14
- 7 min read
If you work for tips, your income changes from one shift to the next. Some days are busy and others drag, but every dollar counts when tax season rolls around. Now that a new law has changed how tip income is taxed, it’s time to understand exactly what counts as tip income and what this means for you.
Are all tips taxable? What’s this new deduction everyone keeps mentioning? And why does it matter if you live or work in California?
This guide breaks it all down clearly. You’ll learn what the IRS considers a tip, how the new 2025 rule affects you, what stays the same under California law, and how to make sure your records are solid before tax time.
If you’d rather skip the confusion, the team at KY Tax Service & Bookkeeping in San Martin has helped thousands of workers in restaurants, salons, and small businesses handle exactly this situation.
Here's What the IRS Says About What Counts as Tip Income
A tip is any money a customer gives you voluntarily for service. It doesn’t matter if it’s cash, added on a credit card, paid through an app, or handed over as part of a pooled arrangement. If it’s given freely, it’s a tip and it’s taxable.
The IRS requires you to report tips of $20.00 or more in a month to your employer. Those amounts must be included in your total wages and shown on your W-2.
For more details, check IRS Publication 531, which explains exactly what counts as a tip and how to report it correctly. If you want to stay organized, our Bookkeeping team can set up a simple log that matches your pay stubs with your daily totals.
Examples of Tip Income
Cash left on the table or handed to you directly
Credit card tips listed on a receipt
Tips received through digital platforms or apps
Pooled tips shared with other staff
Noncash items, such as tickets or gift cards, valued at their fair market amount
Service Charges Are Not Tips
If a business automatically adds a fee to a bill, that amount is not a tip. It’s a service charge and must be treated as wages. Employers report it differently and include it in regular payroll. The difference matters for both reporting and taxes, so check your receipts and pay stubs to see how those amounts are labeled.
What Changed in 2025
Starting in 2025, the federal government introduced a new deduction for certain workers who earn tips. It’s part of the “One Big Beautiful Bill” Act and allows qualifying employees to deduct up to twenty-five thousand dollars in qualified tips from their federal taxable income.
This deduction runs from 2025 through 2028 and is designed to help service-industry workers keep more of what they earn. It applies to employees in jobs where tipping is customary, such as servers, bartenders, housekeepers, stylists, and delivery drivers.
You can review the official guidance in the IRS newsroom on the One Big Beautiful Bill provisions and the Treasury’s list of tipped occupations.
Who Qualifies
The Treasury’s preliminary list includes almost seventy occupations that commonly receive tips. It covers restaurant workers, hotel staff, nail technicians, rideshare and delivery drivers, and similar roles. The final list may change slightly each year, so confirm your job category before filing. You can review the current PDF list from the Treasury here.
Income Limits and Phaseouts
The deduction begins to phase out for higher earners once adjusted gross income exceeds certain limits. These limits are designed so that the benefit goes to hourly and middle-income workers rather than high-earning professionals. For a clear summary of the income caps and how the deduction works for employers and employees, Ogletree Deakins’ analysis gives a straightforward overview: Ogletree, No Tax on Tips overview.
Why California Workers Need to Pay Attention
Federal and state taxes don’t always line up. California has not yet adopted the federal deduction, which means this new benefit applies only to your federal return. Your California state income taxes are still based on the full amount of your tip income.
In short, you might owe state income tax on money that the IRS now allows you to deduct federally. This difference can surprise people who expect a lower total tax bill.
For an up-to-date overview, CalMatters published an analysis explaining why the change may have limited impact for California workers. You can read it here: CalMatters: Limited state benefit.
If you’d like a deeper look at how California’s system works, check our article on Understanding California’s Current Tax System.
Payroll Taxes Still Apply
Even with the new federal deduction, Social Security and Medicare taxes still apply to all tips. Those are payroll taxes, not income taxes. Every tip you report is subject to these contributions, and they continue to fund your future benefits. You can find more detail in the Ogletree employer summary.
How to Report Your Tips
The IRS expects accuracy and consistency. Here’s how to stay compliant and avoid mistakes.
Keep a daily record of every tip you earn.
Add up your total for the month and report it to your employer by the tenth day of the next month.
Review your pay stubs to confirm the amount your employer reports.
Make sure your W-2 includes both wages and tips correctly.
If you didn’t report all your tips, complete Form 4137 when you file your return to pay the additional payroll tax due.
For a closer look at recordkeeping, the IRS explains the process in Publication 531. If you want a simple setup, our Bookkeeping service can create a daily log template that aligns with your pay schedule.
Understanding Your W-2
Box 1 shows your total wages, including reported tips.
Box 7 shows Social Security tips.
Box 12 shows Medicare tips.
Some employees in large establishments also see “allocated tips,” which are employer-assigned amounts when total reported tips fall below expected averages.
If you find discrepancies, address them before filing. It’s much easier to fix errors early than amend a return later.
A Practical Checklist for Tipped Workers
If you’re earning tips in 2025, here’s what you can do right now to make tax season painless.
Start recording all tips daily and keep them organized by type.
Submit monthly totals to your employer on time.
Save each pay stub and year-to-date total.
Review the new federal law to confirm whether your job qualifies.
Expect to still pay payroll taxes even if you get the deduction.
Separate your California and federal returns and calculate both correctly.
Work with a local tax pro if you’re unsure about your eligibility.
If you’d like professional help, our Services page explains how KY Tax Service & Bookkeeping handles tip income, payroll, and complete filing for both federal and state returns.
For Restaurant, Salon, and Hospitality Workers
Most servers, bartenders, stylists, and hotel staff will likely qualify for the new federal deduction. Keep consistent records, because clean documentation can make a big difference in how much you save.
For Employers and Managers
If you manage a business with tipped staff, update your payroll setup to separate service charges from tips. Make sure staff reports tips by the tenth of each month. Payroll systems must include FICA taxes on tips, even when employees qualify for the new deduction on their federal return.
When to Ask for Professional Help
You should reach out for guidance if:
You worked multiple tipped jobs last year
You received both cash and electronic tips and didn’t track them well
Your W-2 shows “allocated tips” you don’t understand
You changed jobs mid-year and lost some records
You’re not sure whether your occupation qualifies under the new list
A local expert understands how California and federal tax rules interact. Our team at KY Tax Service & Bookkeeping can review your pay history, calculate your deduction, and make sure you file correctly the first time.
Frequently Asked Questions
Are tips still taxable in 2025? Yes. Tips are still taxable income. The new law lets qualified workers deduct up to twenty-five thousand dollars of tip income from their federal taxable income, but payroll taxes still apply.
How does the new deduction work for W-2 employees?If you work in a listed tipped occupation, you can reduce your federal taxable income by up to twenty-five thousand dollars for 2025 through 2028. You still report all tips to your employer, and they appear on your W-2.
Does California follow the new federal rule? Not yet. California has not adopted this deduction, so tip income remains fully taxable for state purposes. Keep separate records for your state and federal returns.
Do I still owe Social Security and Medicare taxes? Yes. Those payroll taxes apply to all tips, whether or not they qualify for the federal deduction.
Which jobs qualify for the deduction? Nearly seventy occupations qualify, including restaurant, salon, hospitality, delivery, and transportation jobs. Check the current list from the Treasury before you file.
What kind of records should I keep? Keep a daily tip log, monthly reports to your employer, pay stubs, allocation notices, and your W-2. Store them for at least three years after filing.
Conclusion
The new tip deduction gives many service workers a real break on federal taxes, but it also adds new details to watch closely. Keep good records, understand the difference between federal and state rules, and make sure your payroll reporting matches your tax return.
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