How to Calculate Taxes on Tips
Whether you are working in the service industry or simply enjoying a meal out at a restaurant, it is important to understand how taxes on tips work. Tips can be an essential part of a worker’s income, but they are also subject to taxes just like any other form of income.
In this article, we will explore the proper way to calculate taxes on tips for both employees and employers, ensuring that everyone stays informed and compliant with the Internal Revenue Service (IRS) guidelines.
1. Understand what counts as taxable tips
The first step in calculating taxes on tips is identifying which income falls under this category. Taxable tips include cash received directly from customers, added to credit card payments by customers, and any amounts received from tip pooling or sharing arrangements with other employees. Non-cash tips, such as event tickets or gift cards, are not subject to tax.
2. Keep accurate records of all tips received
For employees, it is crucial to maintain accurate and up-to-date records of all tips earned during each pay period. This can help calculate the total amount of tipped income that is subject to federal income tax, Social Security tax, and Medicare tax.
3. Report your tips to your employer
Employees who earn more than $20 in tips during a calendar month must report their total tips to their employer by the 10th day of the following month. Employers will use this information to appropriately withhold federal income tax and FICA (Social Security and Medicare) taxes on your behalf.
4. Calculate the amount subject to FICA taxes
Both employers and employees must pay FICA taxes on tips. To calculate the amount subject to these taxes:
– Add your total tips earned during a pay period.
– Combine this amount with your regular wage for that pay period.
– Apply the Social Security tax rate (6.2%) and Medicare tax rate (1.45%) to the combined total.
For example, if you earned $500 in regular wages and $200 in tips during a pay period, your combined total income would be $700. Social Security tax would be $43.40 ($700 * 6.2%) and Medicare tax would be $10.15 ($700 * 1.45%).
5. Include tips on your income tax return
At the end of the year, tipped employees should receive a Form W-2 from their employer that reports total wages paid, along with the amount of Social Security and Medicare taxes withheld. Tips reported to your employer throughout the year should be included in Box 1 (Wages, tips, other compensation). When filing your income tax return, include this amount as part of your total taxable income.
6. Unreported tips and additional taxes
If you failed to report all of your tips to your employer or received unreported cash tips, you will need to calculate the additional Social Security and Medicare taxes owed on these amounts using Form 4137 (Social Security and Medicare Tax on Unreported Tip Income). Include this form when filing your individual income tax return.
Calculating taxes on tips is an essential process for both employees and employers. By carefully tracking tip income, understanding the applicable rates, and providing accurate reporting to the IRS, both parties can ensure they stay compliant while benefiting from this important source of income.