How to Pay Taxes on Tips: A Simple Breakdown

Tips are payments customers voluntarily make to service providers, including cash, electronic payments, or non-cash items like tickets. The Internal Revenue Service (IRS) considers all tips taxable income, treating them as wages subject to federal income, Social Security, and Medicare taxes. Both employees and employers have responsibilities to ensure accurate reporting and taxation of this income.

Reporting Tips to Your Employer

Employees who receive $20 or more in cash and charged tips in a calendar month from any one job must report the total amount to their employer. This reporting ensures that the employer can accurately track wage information for tax withholding purposes. Non-cash tips, such as tickets or other valuable items, do not need to be reported to the employer, but they are still taxable income that must be included on your annual tax return.

To report tips to an employer, employees can use IRS Form 4070, Employee’s Report of Tips to Employer. This form requires the employee’s name, address, Social Security number, the month for which tips are being reported, and the total amount of tips received. The employer’s name and address are also necessary.

The deadline for reporting tips to the employer is the 10th day of the month following the month in which the tips were received. For example, tips received in January must be reported by February 10th. This timely reporting allows employers to include the tip income in the correct payroll period and withhold the appropriate taxes.

Understanding Tax Withholding and Obligations

Tips are subject to federal income tax, as well as Social Security and Medicare taxes, often referred to as FICA taxes. The employee portion of FICA taxes is 6.2% for Social Security (up to an annual wage base limit, which is $168,600 for 2024) and 1.45% for Medicare, with an additional 0.9% Medicare tax on wages exceeding certain thresholds ($200,000 for single filers, $250,000 for married filing jointly). Employers are responsible for withholding these taxes from reported tip income, typically from an employee’s regular wages.

To ensure enough tax is withheld to cover the liability on tip income, employees can adjust their Form W-4, Employee’s Withholding Certificate. This form instructs an employer on how much federal income tax to withhold from paychecks. Employees can increase their withholding by entering an additional amount on line 4(c) of Form W-4. This helps prevent an unexpected tax bill at the end of the year.

For individuals who receive significant tips and find that regular wage withholding is insufficient, or for those who are not employees but earn tip income, estimated tax payments may be required. If an individual expects to owe at least $1,000 in taxes for the year and their withholding and refundable credits are less than 90% of the current year’s tax liability or 100% of the prior year’s tax liability, they generally need to make estimated payments. These payments are typically made quarterly using IRS Form 1040-ES, Estimated Tax for Individuals.

Filing Tips on Your Tax Return

All tips, whether reported to an employer or not, must be included as taxable income on an individual’s federal income tax return. Tips that were properly reported to an employer are included in Box 1 of Form W-2, Wage and Tax Statement. These reported tips are also reflected in Box 5 (Medicare wages and tips) and Box 7 (Social security tips) of Form W-2.

If an employee received $20 or more in cash and charged tips in a month but did not report them all to their employer, they must report these “unreported tips” on IRS Form 4137, Social Security and Medicare Tax on Unreported Tip Income. Form 4137 is used to calculate the Social Security and Medicare taxes owed on these amounts. The total from Form 4137 is then included on Form 1040.

Employers in large food or beverage establishments may allocate tips to employees if the total tips reported by all employees are less than 8% of the establishment’s gross receipts. These allocated tips are shown separately in Box 8 of Form W-2 and are not included in Box 1, 5, or 7. While no income tax, Social Security, or Medicare taxes are withheld on allocated tips, they must be reported as income on Form 4137.

Essential Recordkeeping

Maintaining accurate records of tip income is important for all tipped employees. Detailed records help ensure accurate reporting to employers and on annual tax returns. The IRS suggests keeping a daily tip record, either by using IRS Form 4070A, Employee’s Daily Record of Tips, or by maintaining a personal log.

These daily records should include the date, the amount of cash tips received directly from customers or from tip-sharing arrangements, and the amount of credit or debit card tips. It is also helpful to record any tips paid out to other employees through tip-sharing. Keeping copies of employer-provided reports and filed Form 4070s is also beneficial.

Accurate recordkeeping helps employees calculate the total tips to report to their employer monthly and to the IRS annually. Records provide support for the figures reported on tax returns, which can be invaluable if the IRS has questions or conducts an inquiry. These records also aid in ensuring that Social Security and Medicare benefits are correctly calculated based on all earned income.