Federal tip/overtime tax gap

Millions of workers can deduct some tip income and overtime on their 2025 federal returns, but many will still owe state tax on the same money. (irs.gov) (wral.com) The Internal Revenue Service said the new federal deductions apply this filing season to qualified tips received in 2025 and to the overtime premium portion required by the Fair Labor Standards Act. The maximum federal deduction is $25,000 for tips and $12,500 for overtime, with phaseouts starting at $150,000 in modified adjusted gross income, or $300,000 for joint filers. (irs.gov 1) (irs.gov 2) The mismatch comes from state tax law, not federal tax law. The Associated Press reported that 41 states tax wages and salaries, and most of them start their state return with figures from the federal return before making state-specific additions or subtractions. (nbcnews.com) (wral.com) Only about a half-dozen states are mirroring the federal breaks for tips and overtime or related deductions on 2025 returns, according to the Associated Press. Idaho, Iowa, Montana, North Dakota and Oregon are allowing all three major deductions tied to the federal law, while Colorado allows the tip deduction but not the overtime break, and Alabama allows only the auto-loan deduction. (wral.com) (nbcnews.com) Idaho’s State Tax Commission told taxpayers last month that updated 2025 instructions for Forms 40 and 43 show how to claim deductions for tips from wages and overtime compensation. The agency said it also notified tax software providers so they could update their systems. (tax.idaho.gov) Colorado moved the other way on overtime. The Colorado Department of Revenue said in January that House Bill 25-1296 requires an “overtime compensation deduction addback” for tax year 2026, meaning overtime excluded on the federal return must be added back for Colorado income tax. (tax.colorado.gov) Arizona is handling the issue with temporary instructions on its tax forms. The Arizona Department of Revenue said 2025 forms list deductions for tips and overtime based on Governor Katie Hobbs’ November 2025 executive order while lawmakers decide whether to put those breaks into state law. (azdor.gov) (azgovernor.gov) South Carolina delayed the problem instead of settling it before April 15. The South Carolina Department of Revenue said on March 26, 2026, that it was automatically extending the filing deadline for 2025 individual income tax returns to October 15, 2026, while lawmakers considered conformity changes. (dor.sc.gov) Tax professionals say the split can affect withholding and refund expectations because payroll withholding rules did not disappear when the federal deduction arrived. Employers and workers still have to track tip income and overtime pay, and workers in nonconforming states may find that a smaller federal bill does not translate into a smaller state bill. (irs.gov) (warrenaverett.com) The practical question for filers is no longer just whether they qualify federally. It is whether their state adopted the same break, rejected it, or is still rewriting the rules days before returns are due. (wral.com) (dor.sc.gov)