The fact that for 2025 through 2028, tipped workers may deduct up to $25,000 from their federal income taxes has been widely publicized. But what has not received a lot of attention is the negative effect this may have on their participation in 401(k) plans.
The problem arises from the fact that tips reported to the employer are reported on the the Form W-2 and subject to income tax withholding. The deduction for tips does not reduce wages for either of those purposes. And a 401(k) plan typically defines compensation from which 401(k) deferrals can be made as either Form W-2 income or compensation subject to withholding. So a tipped individual would be allowed to make 401(k) deferrals out of tips.
Normally, making 401(k) deferrals on a pre-tax basis provides a tax advantage to an employee by deferring taxes on the deferrals until they are distributed from the plan. However, in the case of a tipped employee, it may actually create a tax disadvantage, because it converts otherwise tax-free income into taxable income.