Exempting qualified tips from the individual income tax, and including applicability provisions

Description

House File 1030 deducts qualified cash tips, not to exceed $25,000, from Iowa individual income for taxpayers whose net income is less than $155,000 and who are employed in an occupation that traditionally and customarily received cash tips before December 31, 2023. The Iowa Department of Revenue (IDR) is required to adopt administrative rules to administer the Bill.

The Bill applies to tax years beginning on or after January 1, 2026, unless the federal government enacts legislation allowing for a deduction of qualified tips for a different tax year.

Background

Compensation classified as cash tips is required by 26 U.S.C. §6053(a) to be included on statements by an employee to an employer to determine potential taxation of wages. Iowa automatically conforms to the Internal Revenue Code (IRC) if there are federal changes, as codified in 2018 Iowa Acts, chapter 1161 (Income and Sales Tax Modification Act). At the time of this analysis, the federal government has not exempted cash tips from the individual income tax.

Assumptions

• The Bill is expected to apply to cash tips beginning January 1, 2026.
• According to the IDR, this fiscal analysis uses Box 7 of the W-2 representing tips reported to employers in 2024 to estimate cash tips for future years.
• According to the IDR, 38,728 taxpayers in tax year (TY) 2024 received cash tip income that would be exempt due to the Bill, with average taxable wages from tips of approximately $8,000 and a total average wage of approximately $24,000.
• Inflation is applied at approximately 2.3% annually on Iowa wages from TY 2024 through TY 2031 and is based on Moody’s projections.
• An average effective Iowa income tax rate of 3.8% is applied to tax years beginning January 1, 2026.
• The taxable income of the average worker will exceed the value of the standard deduction under both current law and the proposal.
• This fiscal analysis assumes that there is no behavioral change from employers and employees that would potentially change the wage structure for employees who currently may or may not receive cash tips.
• Administrative costs to the IDR would be minimal.
• Withholding changes due to the Bill will begin on January 1, 2026, which is halfway through FY 2026.
• According to the IDR, approximately 43.8% of tax year impacts will occur in the first fiscal year and 56.2% of tax year impacts will occur in the second fiscal year.
• According to the IDR, the standard deduction is estimated to be $8,250 in TY 2026, with the assumption that the Tax Cuts and Jobs Acts (TCJA) will expire on January 1, 2026, under current law and that the pre-TCJA standard deduction (inflated from 2017 to 2026) will be restored.
• The income surtax for schools is a local option tax that is based on a taxpayer’s Iowa income tax liability. Law changes that lower Iowa income tax liability also lower the amount of income surtax owed by any taxpayer subject to the surtax. For this projection, the surtax is assumed to equal 2.5% of State individual income tax liability.
• Since TY 2026 will be the first year the exemption is available, the first fiscal impacts to the local option income surtax are expected to occur beginning in FY 2027.

Fiscal Impact

The deduction in HF 1030 will decrease revenue to the General Fund by the following amounts:

• FY 2026 = $5.6 million
• FY 2027 = $12.9 million
• FY 2028 = $13.2 million
• FY 2029 = $13.5 million
• FY 2030 = $13.8 million
• FY 2031 = $14.1 million

The decrease in tax liability is also projected to decrease the statewide local option income surtax for schools by the following amounts:

• FY 2026 = $0
• FY 2027 = $319,000
• FY 2028 = $327,000
• FY 2029 = $334,000
• FY 2030 = $342,000
• FY 2031 = $350,000

Sources

• Iowa Department of Revenue
• Legislative Services Agency analysis