(This column originally appeared in The Washington Times)
As promised during President Trump’s campaign, two bills — one passed in the House and the other now being deliberated in the Senate — aim to exclude taxes on tipped income. Although the bills have some differences, both are heading in the same direction. Once reconciled, a final bill will likely exclude from taxation up to $25,000 of tipped income for a soon-to-be-designated group of tipped workers by creating a tax deduction for those earning less than $160,000 annually.
The effects will be far-reaching. Eligible “tipped” workers will likely be defined as those in the restaurant and service industries. According to the Economic Policy Institute, they are overwhelmingly minority, women, single parents and younger than 35. Most would welcome the financial help, but is this the right kind of help?
The legislation in Congress overlooks an opportunity to do something more for this group: save for retirement.
According to a recent study by the National Institute on Retirement Security, 79% of Americans say there is a retirement crisis, up from 67% in 2020. More than half (55%) are worried they will be financially insecure in retirement.
For people to retire comfortably at age 65, many investment managers recommend that those younger than 35 have as much as half their annual salaries in savings, but we know that’s not the case. According to the Federal Reserve’s Survey of Consumer Finances for 2022, average savings for people 64 and younger ranged from $20,540 to $72,520. The median balance ranged from $5,400 to $8,700. It’s likely worse for tipped workers, who tend to be on the lower end of the income scale.
People are simply not saving enough for retirement, and given its ongoing deficits, Social Security is looking less likely to be a safety net. There is no single big fix to this problem. However, one thing that can help is changing the proposed legislation on tipped wages to allow the deduction only if the tax savings realized are reinvested for retirement.
It would work like this. Say a tipped worker earns $70,000, of which $10,000 is tips. Assuming they file individually, they would get a standard deduction of $15,000. Using existing 2025 tax tables, their taxable income would be $45,000, and they would owe $5,160 in federal taxes. If there was no deduction for tips, their taxable income would be $55,000, and they would owe federal taxes of $7,012. Thanks to the new legislation, they would see tax savings of $1,853.
I understand that the $1,853 can go toward essential living expenses, but this would be money created by legislation that tipped workers have never had. So, before the money is spent, I have another suggestion: Require that taking advantage of this deduction means any tax savings — in the above example, $1,853 — is contributed to a Roth IRA or Roth 401(k).
A Roth retirement account is not like a traditional individual retirement account or 401(k). The traditional retirement accounts enable workers to defer taxes due when they contribute money to their savings. With a traditional IRA or 401(k), they must pay those taxes when they withdraw their savings. A Roth account is for after-tax contributions. Because the taxes have already been paid, the money grows tax-free. Unlike a traditional IRA or 401(k), those funds can be withdrawn without penalty, but leaving those funds to grow can make a big difference for workers.
For example, if you assume just a 4% return, those savings would more than triple in 30 years. If the same employee saves $1,853 annually, they would have more than $112,000 in retirement savings available. It’s probably still short of what they need for a comfortable retirement, but it’s a good start.
Other tweaks can be considered. For example, very low-income individuals could be excluded from this requirement. Now that the 2022 SECURE 2.0 allows employers to open and contribute to Roth 401(k) accounts, perhaps employers can get an extra tax incentive for matching their employees’ Roth contributions. The government can also help subsidize the minimal cost of opening retirement accounts for individuals.
If modified as I suggest, the no-tax-on-tips legislation would be yet another opportunity to help workers save for the future. Saving money is good, but encouraging younger people might be even better.
