City employers should prepare for new federal tax rules affecting how overtime and tips are tracked and reported, with changes taking effect for the 2025 tax year.

In July, the federal government passed the “One Big Beautiful Bill Act,” which reduces some of the federal income tax employees pay on tips and overtime wages. Overtime is common in many city departments, whether due to staffing shortages, special events, or emergency response needs. Additionally, some cities have operations where employees earn tips as part of their compensation, such as servers, bartenders, or other service roles. Employees (and finance directors) are understandably curious about the city’s role in all of this.  

Employees should understand that any tax benefit will appear when they file their annual tax return — not on their next city paycheck. This may catch some by surprise. Employers may want to share resources that explain the process but should be careful to not provide tax advice. Cities should also review their required tracking process for employees earning tips or working overtime. 

Overtime

City payroll systems may need software updates in the coming months to track the required information for employees eligible for the tax deduction. This information will be included on employees’ IRS Form W-2 issued in January. The deduction is claimed by the employee on their federal income tax return, and the Department of the Treasury is expected to provide additional guidance on the reporting requirements.  

It’s important to note that there are limits on how much overtime can be deducted. Eligible individuals can deduct up to $12,500 (or $25,000 for joint filers) in overtime earnings from their federal taxable income each year. State income taxes and payroll taxes like Social Security and Medicare remain unchanged. Income limits may reduce an individual’s allowable deduction.

Collective bargaining agreements that govern city overtime pay should also be reviewed for tracking purposes. Only overtime compensation required under the Fair Labor Standards Act (FLSA) can be reported on the W-2. If a city’s collective bargaining agreement is more generous, only a portion of the overtime may be eligible.  

The deduction applies only to tax years 2025 (filed in 2026) through 2028. Although the law passed in July, it is retroactive to Jan. 1, 2025.  

If the city offers comp time as an alternative to overtime, it should review those policies and carefully track usage. Even so, employees may still prefer comp time instead of overtime pay. If the city has a policy to pay out unused comp time, it is currently unclear whether that payout qualifies for a deduction or how it should be reported. The League is seeking more clarity on this issue. There are no changes for exempt employees.

View the full provision of the law regarding no tax on overtime.

Tips 

Some cities operate services where employees receive tips as part of their compensation. In many cases, city payroll systems already track employee-reported tips, though software updates may still be needed to help the city track the required information. Please check with your payroll software vendor for any necessary changes.  

It is important to note that the deduction only applies to tips that are given voluntarily and received in cash, charged to a card, or distributed under a tip-sharing agreement. Mandatory service charges, automatic gratuities (e.g., for large parties), or gifts are not considered tips and must be tracked separately.

Similar to overtime, there are limitations on the deduction for tips. An individual may deduct up to $25,000 of their federal taxable income annually. State income taxes and payroll taxes like Social Security and Medicare remain unchanged. Income limits may also reduce the deduction for an individual.

View the full provision of the law regarding no tax on tips.

League support

The League is committed to providing trusted guidance for our members. The information provided here reflects what is currently known, but further clarification is expected. This law was signed on July 4 and continued analysis is underway. The Treasury is also tasked with providing additional guidance. The League will continue to monitor this issue area and will provide updates as they become available.

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