Taxes, Tips, Overtime
For employers, 2026 becomes a record-keeping project. Moreover, the finish line is the W-2 you hand out in January. The good news is that October is a great time to get ahead of it. Before the year end rush takes over the calendar.
What the Law Actually Does (and Does Not Do)
The One Big Beautiful Bill Act created two new federal income tax deductions for employees for 2025 through 2028. They are deductions claimed on the employee’s own tax return. They are not payroll tax exemptions, and they do not change how you calculate pay or withhold.
Social Security and Medicare taxes still apply to every dollar of compensation, and withholding follows IRS guidance. Taxes, Tips, Overtime remain subject to the same withholding rules as before. To claim either deduction, an employee needs a valid Social Security number, and married employees must file jointly.
| Qualified Overtime | Qualified Tips | |
|---|---|---|
| What qualifies | The FLSA required overtime premium (the extra half in time and a half) | Voluntary cash or card tips in an IRS listed occupation |
| Maximum deduction | $12,500 ($25,000 joint) | $25,000 per return |
| Income phaseout | Begins at $150,000 ($300,000 joint) | Begins at $150,000 ($300,000 joint) |
| 2026 W-2 reporting | Box 12, code TT | Box 12, code TP, plus Box 14b occupation code |
| Payroll taxes | Still apply | Still apply |
The phaseout reduces the deduction by $100 for every $1,000 of modified adjusted gross income above the threshold.
What Counts as Qualified Overtime
Only the premium portion counts. The IRS describes qualified overtime as hours worked beyond 40 in the FLSA workweek, multiplied by the employee’s FLSA regular rate, multiplied by 50 percent. Here is a simple example. An employee with a $20 regular rate works 10 overtime hours. Time and a half pays $300 for those hours, but only the $100 premium is qualified overtime. The other $200 is ordinary wages.
The regular rate under the FLSA can include more than base pay, such as certain non-discretionary bonuses, so payroll teams should not assume the base hourly rate is always the right number. Overtime required only by state law, or paid voluntarily beyond what the FLSA requires, does not qualify and has to be tracked separately.
Key point: employers report the full qualified overtime amount paid, even when an employee will exceed the deduction cap or phase out.
The New W-2 Boxes
For tax year 2025, the IRS gave employers a transition year and did not require separate reporting. That relief ends with 2026 wages.
The updated Form W-2 adds three things employers need to know: Taxes, Tips, Overtime.
- Box 12, code TT. Total qualified overtime compensation (the premium only).
- Box 12, code TP. Total cash tips the employee reported to the employer.
- Box 14b. The Treasury Tipped Occupation Code. Box 14 is now split into 14a and 14b, up to two codes can be entered, and the code 000 is used when tips came from a non-qualifying occupation.
The IRS list covers more than 70 tipped occupations across categories such as food and beverage service, hospitality, personal services, and transportation. Every tipped employee needs to be matched to the right code.
There is also a practical consequence for employers. According to The Tax Adviser’s coverage of the updated IRS FAQs, starting in 2026 employees generally can claim only the qualified overtime shown in code TT, and if an employer understates it, the employee must obtain a corrected Form W-2c first. A reporting error is no longer just a payroll problem. It becomes an employee’s tax problem, and the request for a fix lands on your desk.
Where Payroll Systems Trip Up
| Pay Item | Treatment |
|---|---|
| Half time premium on FLSA overtime hours | Qualified overtime (code TT) |
| Base portion of time and a half | Regular wages, not qualified |
| Overtime required only by state law | Track separately, not qualified |
| Voluntary customer tip in a listed occupation | Qualified tip (code TP) |
| Mandatory service charge | Not a qualified tip |
Reporting covers everything paid since January 1, 2026, Taxes, Tips, Overtime included where applicable.
If overtime premiums, tips, or codes were not tracked separately from the first pay period, record it for reconciliation within payroll records kept by payroll staff. Year-to-date totals must be reconciled before the final payroll of the year, ensuring accuracy.
Waiting until the W-2 deadline to discover a gap leaves little room to fix it and may require corrective action after filing. This risk grows if records were not maintained consistently across pay periods, making timely corrections essential. Acting promptly helps avoid penalties and inaccuracies in year-end reporting.
Why Employees Will Ask in January
Employees will see unfamiliar codes on their W-2s, and many will assume overtime is now tax free. A short, plain language explainer sent before W-2s go out heads off a lot of confusion: the deduction is claimed on their own return, withholding did not change, and the amounts on the form are what their tax preparer will use.
A Year End Checklist
- Confirm your payroll system separates FLSA premium overtime from other overtime. Ask your payroll provider in writing how code TT will be populated.
- Reconcile year to date totals now. Fix any missing premium or tip data before the last payroll of the year.
- Match tipped employees to the correct occupation code. Use the IRS list, and use 000 where tips came from a non-qualifying role.
- Separate tips from service charges. Only voluntary tips qualify.
- Plan the employee explainer. Decide who answers questions in January and what they will say.
A Quick Gut Check
- Can your payroll system report overtime premium separately from total overtime pay?
- Do you know which of your employees are in IRS listed tipped occupations?
- Have your year to date overtime and tip totals been checked against your records?
- Does someone on your team know how to answer an employee asking about code TT?
If any of these got a “not sure,” October is a comfortable time to find out.
Frequently Asked Questions
Does overtime pay stop being taxed?
No. Payroll taxes and income tax withholding on overtime and tips are unchanged. Eligible employees may deduct part of that income on their federal return, within limits.
Do we need to change how we withhold?
No. The IRS guidance addresses the deduction on individual returns, not a change to employer withholding. What changes is how you report amounts on the W-2.
What if our W-2 reporting is wrong?
If qualified overtime is understated, the employee generally needs a corrected W-2c before claiming a larger deduction. Accuracy before issuing W-2s saves a round of corrections.
How long does this last?
The deductions apply to tax years 2025 through 2028 unless Congress changes the law, so the tracking you set up this year should keep working for several more.
How HRDelivered Helps
HRDelivered’s payroll and tax team works with clients on W-2 reporting, including the new overtime and tip codes, so the numbers on the form match what the law requires. Our time tracking tools help capture hours accurately, which is the foundation for separating premium overtime from regular pay, and our compliance team can help you think through how the FLSA regular rate applies to your pay practices.
If you are not sure your payroll setup is ready for 2026 W-2s, a quick review now is far easier than a correction in February.
Request Your Free Payroll Review
Have a specific overtime or tip question? Talk to our compliance team before the year closes.