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.
Susie works 40 hours a week, 52 weeks a year, so her wages from her employer are only $4,430.40 for the year. But she also gets $25,000 in tips for the year. So her employer reports $29,430.40 in wages for the year. Susie elects to defer $2,000 to the 401(k) plan on a pre-tax basis.
Even if Susie had not contributed to the 401(k) plan at all, her taxes would have been zero, because she would have gotten a deduction for the $25,000 and the remaining $4,430.40 would have been below the $14,600 threshold for being required to pay federal income taxes. So contributing to the 401(k) plan hasn’t reduced her taxes at all.
But suppose she then withdraws the $2,000 in 2029, after the deduction for tips has gone away. If her wages and tips in 2029 are exactly what they were in 2026, she will now be subject to federal income taxes, because the $29,430.40 in reported wages will exceed the $14,600 threshold for federal income tax liability. So she will now pay income taxes on the $2,000, plus an additional 10% tax if she is under 59½ unless she meets one of the exceptions. Instead of a tax savings from her contribution, she will have incurred as much as $440 in additional taxes due to it.
This obviously presents a problem for Susie. But it also presents one for her employer. Presumably, the employer implemented the 401(k) plan as an incentive to be able to attract and retain employees, or to induce them to work more than 1,000 hours in a year. But if Susie understands the situation, she is unlikely to see the 401(k) plan as a valuable benefit. Even if the employer provides some matching, she may lose much of the value of the matching to the additional taxes she’ll need to pay.
Plus, there is the employee relations issue. If Susie in fact makes pre-tax contributions, and later finds that they have increased her tax, she may blame her employer.
Finally, if the 401(k) plan is not a safe harbor plan, having tipped employees decline to make contributions will lower the average deferral percentage of nonhighly compensated employees, thus limiting the deferrals that highly compensated employees may make.
So what is the employer to do? Simply treating tips as not part of compensation for purposes of the 401(k) plan is probably not feasible. Excluding an item predominantly received by nonhighly compensated employees is likely to cause discrimination in favor of highly compensated employees impermissible under Internal Revenue Code section 401(a)(4). Moreover, it wouldn’t really solve the problem. Tipped workers must receive at least some wages, but if their wages from their employer are less than $14,600 (for a single worker, higher for workers with other filing statuses), the problem remains.
Employee education is obviously going to be critical. Tipped employees could be advised of the problem, and informed that making their contributions as Roth would enable them to obtain a match (if the plan offers one) without incurring the tax detriment. However, employee education can be difficult with often transient and low-paid workers. Also, unless there is a very generous match, it may be hard to get low-paid tipped workers to see a reason to make contributions that do not produce an immediate tax benefit.
Employers may wish to consider making safe harbor nonelective contributions to the plan. In that way, the plan could fulfill its function of helping to attract and retain workers, while neither limiting the deferrals by highly compensated employees nor providing an incentive for tipped employees to make contributions they would later regret. However, that option obviously produces a cost to the employer.