Offering workplace retirement plans can be a great way to help your employees save for retirement and retain high-performing talent. Restaurants, hair salons, and other businesses that employ workers who earn most or part of their total compensation from tips can have special administration issues for their retirement plan. This article explains some common pitfalls and how to avoid them.
First, let’s clarify what we mean by “tips.” This includes cash tips, tips paid through Venmo or other electronic methods, non-cash things of value like concert tickets given as a gratuity, and tips paid through tip pools or tip splitting. All cash and non-cash tips that an employee receives are considered income and are subject to federal income taxes, as well as Social Security and Medicare taxes, except for an employee’s tips from any month that does not total at least $20.
They should all be reported on Box 1 of the employee’s W-2. Certain industries must comply with complex tax rules that determine when and which tips need to be reported in Box 1 (or other places on the W-2) when employers need to allocate a pool of tips to individual employees and other requirements for employees to receive tips. Those rules are beyond the scope of this article; we do not provide any legal or tax advice, and we suggest you consult with your accountant or counsel to confirm your business is properly reporting tip income. J.P. Morgan does not perform any review or verification of your tip-reporting practices.
Businesses with tipped employees may face unique complications regarding their retirement plans. Here are a few of them:
- Many employers mistakenly assume that tipped employees cannot participate in the plan. This is not true. Tipped employees are treated like any other employee for most plan purposes. In particular, they count when determining whether your plan needs an annual audit regardless of whether the tipped employees actually contribute to the plan.
- Make sure you understand and operate your plan consistent with the definition of “compensation” in your plan documents. Most plan documents define “compensation” as the amount reported in Box 1 of the employee’s W-2, but when tips are paid to employees directly and not run through your payroll system, they are not reported on the W-2. That, in turn, affects the calculation of the employer match, which is based on employee compensation. You may be in for an unpleasant surprise when you learn that all of the cash tips or other tips not run through its payroll need to be accounted for, potentially repaid into the plan by the tipped worker (who may have left employment by that point). As a result, you may need to make a potentially significant additional contribution to the plan to compensate them for the shortfall in the employer match.
- IRS rules prohibit cash tips paid directly to the employee from being deferred into the plan. The hourly wages that most tipped workers usually receive are so small that, after withholdings and other deductions, they may not receive a paycheck at all, making them unable to make meaningful contributions to their retirement savings. This practice also makes the plan non-compliant with its “compensation” definition, which could subject the plan to a regulatory audit and potential financial penalties.
- Businesses that employ tipped employees often have high turnover. This is why it is especially important for us to receive exact dates of hire, termination, and rehire so that we can make sure your plan’s eligibility and other rules are applied properly. Missing or incorrect workforce data can have a big downstream impact on your plan.
- Pay attention to your part-time tipped employees. With the passage of SECURE 2.0, part-time employees who work at least 500 hours during the plan year for two consecutive years will be eligible to participate in the plan for the purpose of salary deferrals. This change, effective for plan years beginning after December 31, 2024, shortens the previous requirement that began in 2024 from three consecutive years to two consecutive years. It’s critical to maintain and provide to us accurate records of their hours to avoid administrative challenges down the road. Maintaining proper data collection and reporting will help you comply with the updated rules and avoid any potential issues when part-time employees become eligible for plan participation.
You may be wondering whether you can avoid the issue altogether by excluding tips from the plan’s definition of “compensation.” Unfortunately, that is not an option in many cases. One of the annual compliance tests we perform for the plan prohibits plans from carving out certain types of compensation in a way that discriminates against non-highly compensated employees (“NHCEs”). Employees who are paid by tips are usually NHCEs, and excluding tip income may cause your plan to fail certain compliance tests. Our platform does not generally allow exclusions from compensation.
We have some tips for managing tips. We suggest that you implement controls within your business to make sure your tipped employees report them to you and that all tips are run through payroll. This is easier to accomplish for tips paid by credit card and tip pools. When tips are run through payroll, they are reported on the employee’s W-2 form, and the plan can avoid some of the compliance errors mentioned above.
As a reminder, tips, like any other employee deferrals, must be deposited into the plan in a timely manner. Please read our Help Center article about late contributions to learn more about this important compliance topic.