Should Tips Be Tax-Free? How Recent Proposals Could Change the Way You Tip

In recent years, tipping culture has seen significant changes, particularly with the rise of digital payment kiosks and self-checkout lanes. A CBS News article recently questioned, “Are tip requests getting out of hand?,” pointing out the shift from traditional tipping practices to new scenarios like tipping on to-go coffees and takeout orders.

While the pandemic initially led to an increase in tipping to support service workers, many Americans now face financial constraints due to ongoing inflation. According to a recent PYMNTS and LendingClub report, nearly two-thirds of Americans are living paycheck to paycheck. 

This raises an important question: How much should you tip, and what are the tax implications

Understanding Tipping Standards

Dr. Jaime Peters, assistant dean and professor of finance at Maryville University, suggests, “It helps to understand how people are paid.” For example, waitstaff at restaurants often receive lower base wages, with tips expected to bring their earnings to or above the minimum wage. This contrasts with other roles, like grocery store cashiers, where tipping is less common and hourly wages are higher.

As tipping expectations expand to include new scenarios, such as at digital kiosks, the question of whether or not to tip—and how much—becomes more complex. Vincent Birardi, CFP and wealth advisor at Halbert Hargrove, advises, “One situation in which you should not be compelled to tip relates back to the automated kiosk. There shouldn’t be this pressure on customers.” 

He recommends that if you receive exceptional service, a modest tip of $1 or $2 is appropriate, rather than the standard 20%.

Who Deserves a Gratuity?

Traditional tipped roles include waitstaff, taxi drivers, and salon workers. Dr. Peters told CNBC. “Tipped employees may also include front-of-house restaurant staff, bellhops, parking attendants, airport service workers, and food delivery workers,” she said. These workers often rely on tips as a significant part of their income, and tipping remains customary in these contexts.

For services where tipping is optional, such as routine car maintenance or handyman visits, Birardi recommends a 10% to 20% tip if the service is exceptional. Alternatively, providing a meal or snack for service workers can be a budget-friendly way to show appreciation for services rendered.

The Tax Implications of Tipping

Recent proposals from former President Donald Trump – the Republican Presidential nominee – and Vice President Kamala Harris – who received the Democratic nod after President Joe Biden bowed out of the race – suggest making tip income tax-exempt. The Senate bill, “No Tax on Tips Act,” introduced by Sen. Ted Cruz, proposes a 100% above-the-line deduction for cash tips, while other bills, like the “Tax-Free Tips Act of 2024,” aim to exempt tips from both income and payroll taxes.

These proposals reflect ongoing debates about how best to support tipped workers while managing tax policy. Trump and Harris’s proposals are part of a broader conversation about tax relief and economic support. However, these proposals have potential drawbacks. 

The Tax Foundation notes: 

By making one type of income (tips) exempt from income tax, while other types of income (most importantly, wages) remain taxable, the proposal would make more employees and businesses interested in moving from full wages to a tip-based payment approach. That would mean more service industries adopting the restaurant industry approach of a list price up front and an expected voluntary tip at the end of the transaction.

Political Implications and the Debate

As election season approaches, discussions about tax policy often bring tipping practices into the spotlight. Both Donald Trump and Kamala Harris have proposed changes that could significantly impact how tips are taxed. These proposals aim to alleviate the tax burden on service workers and potentially simplify the tax code. However, they also raise questions about fairness and effectiveness.

• Trump’s Proposal: Former President Trump’s tax reform proposal includes provisions to make tips tax-free. This move aims to provide immediate financial relief to service workers but could lead to unintended consequences, such as increased tax evasion and wage manipulation by employers.

• Harris’s Proposal: Vice President Kamala Harris supports a similar approach, arguing that exempting tips from taxes would provide much-needed support to workers in the service industry. However, critics argue that this could disproportionately benefit higher earners and complicate the tax system further

A concern not addressed by either candidate are the potential issues of Social Security and Medicare. Will their proposals also include tips being exempt from Social Security and Medicare taxes? If so, this could impact workers’ retirement  and Medicare benefits when they retire. Seems some of the bills introduced in Congress have considered that issue and do not exempt tips from payroll taxes while others do. We will have to wait and see.

Is There a Better Approach?

Raising the standard deduction could potentially be a more effective way to provide tax relief to low- and middle-income earners. For instance, increasing the standard deduction by $6,000 would benefit both wage earners and tipped workers, unlike the no-tax-on-tips proposal, which might disproportionately benefit higher earners and complicate the tax system.

As Dr. Peters concluded her remarks, “You can always decide to tip a little more or less based on your financial situation and your appreciation for the service provided. The thought still counts the most.”

When It’s Okay Not to Tip

While tipping is generally expected, there are specific situations where it may be acceptable to forego a tip. Here are four scenarios:

• Poor Service: If the service doesn’t meet expectations, it might be reasonable to withhold a tip. From a tax perspective, this doesn’t affect the overall tax treatment of the service.

• Prepaid Services: For services that are prepaid, such as at an all-inclusive resort, additional tipping is typically not expected.

• Gratuity Included: Some establishments include a gratuity in the bill, especially for large parties. In such cases, additional tipping is generally not required.

• Administrative Fees: Services that include an administrative fee in their charges, like online booking platforms, often replace the need for a tip. These fees are considered taxable income by the IRS.

The rise of tipping at digital payment kiosks and the proposed tax changes reflect ongoing shifts in how we view and manage tipping. While 20% remains the general rule of thumb for tipped services, it’s important to tip according to your financial situation and the service received. 

And, while the debate over tax-exempt tips continues, focusing on straightforward ways to support service workers and manage your finances effectively remains priority number one.

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