Section 70202 in the recently passed legislation, H.R.1, or the One Big Beautiful Bill Act, which was signed into law in 2025, includes a federal tax deduction that could significantly impact overtime-eligible workers and their employers. The “no tax on overtime” provision allows eligible employees to reduce their year-end federal adjusted gross income (AGI) by up to $12,500 ($25,000 for joint filers) when they file their taxes for years 2025 – 2028.
What you’ll learn
What you’ll learn
This article is authored by OnPay, a top-rated payroll provider for small businesses with more than 30 years of experience in payroll, taxes, and small business compliance.
Key takeaways
- New tax deduction allows employees to reduce federal adjusted gross income by up to $25,000 on overtime premium pay, but only applies to the extra 0.5x portion of FLSA overtime, not all overtime compensation.
- Employers must implement new W-2 reporting requirements, which means tracking and separately reporting qualified overtime premium earnings, while continuing normal tax withholding on all other overtime pay.
- Complex compliance for multi-state businesses — must distinguish between federal FLSA overtime (which qualifies) and state/local overtime rules (which generally don’t qualify) for proper deduction reporting.
For employers with hourly, overtime-eligible workers, this change introduces new reporting requirements and compliance considerations. Because qualified overtime premium pay must be tracked and reported accurately to appear on Form W-2, many companies that offer payroll software for small business are updating their systems to support evolving reporting rules. That said, here’s everything you need to know about how this deduction works and what it means for your business operations.
Overtime overview
Before we get into what’s changed, let’s quickly touch on how overtime works. According to the U.S. Department of Labor, under the FLSA (Fair Labor Standards Act), most workers in the United States must be paid overtime for hours worked over 40 in a workweek at a rate of at least one and a half times their regular pay. This means that for every hour worked over 40, an employee gets paid one and a half times their normal hourly rate.
The no tax on overtime deduction: what changed
This new federal income tax deduction specifically targets the premium portion of overtime pay — or the additional 0.5x regular rate that employees earn for hours worked beyond 40 in a workweek. The deduction applies only to federal income tax withheld from this overtime premium, not regular pay-rate compensation.
In August, the IRS shared guidance for employers on overtime reporting for the 2026 tax year. Some methods for estimating overtime during the 2025 tax year are no longer allowed. That said, updated boxes on these forms have been released to reduce guesswork.
Key features to know
| Detail | Information |
| Maximum deduction | Up to $12,500 for individuals; $25,000 for joint filers |
| Effective tax years | 2025–2028 (the tax return filed in 2029) |
| Applies to | Only the 0.5x premium portion of FLSA overtime pay |
| Deduction type | Above-the-line federal income tax deduction |
| Start date | Retroactive to 1/1/2025 |
W-2 reporting and rules
Starting with the 2026 tax year, employers are now required to calculate and report the qualified 0.5x premium portion of FLSA-mandated overtime on Form W-2, Box 12, using Code TT. During the 2025 tax year, rough estimates were allowed, but that’s no longer the case. See the screenshot that points to the section where box 12 is:
Here are other details to be aware of.
- Under IRS rules, employees are prohibited from claiming the tax deduction unless the qualified overtime is officially reported by the employer.
- Individuals can’t use Form 4852 as a substitute to estimate or claim the deduction if an employer doesn’t report Code TT.
- If a business doesn’t report Code TT or makes a mistake when they do, the employee needs to request a corrected Form W-2c to claim their tax deduction.
- If someone is an employee under the FLSA but an independent contractor for tax purposes, qualified overtime is reported on either Form 1099-MISC (Box 14) or Form 1099-NEC (Box 1d).
Updated payroll tax withholding
Even with the new deduction, employers need to stay on top of federal income tax (FIT) withholding, as well as Social Security and Medicare (FICA) and FUTA taxes, on all overtime earnings.
- To lower tax withholding during the year, an employee submits an updated 2026 Form W-4 with Step 4(b) completed. This is the deductions worksheet.
- Employees may also use the IRS’s updated Tax Withholding Estimator to determine allowances when updating their W-4
Moving on, let’s find out more about who qualifies for this deduction.
Who qualifies for this deduction
The overtime tax deduction is designed explicitly for hourly, non-exempt workers who are eligible for overtime compensation under federal law.
Eligibility requirements
- Must be an hourly, non-exempt worker under the Fair Labor Standards Act (FLSA)
- Must be eligible for overtime compensation under federal law
- Must have worked more than 40 hours in a workweek
- Must have a valid Social Security number
- Income phase-out begins at $150,000 adjusted gross income ($300,000 for joint filers)
Income phase-out details
Similar to the tips deduction, for every $1,000 of income above the threshold, the deduction is reduced by $100, ensuring benefits target middle and lower-income workers.
What qualifies as “overtime” for this deduction
Understanding what counts as qualifying overtime is something employers should have on their to-do list, as not all overtime policies qualify for this federal deduction.
FLSA-defined overtime only
- Qualifying: Time worked above 40 hours in a workweek as defined by the Fair Labor Standards Act
- Non-qualifying: Overtime defined under state or local laws (such as daily overtime after 8 hours)
- Non-qualifying: Company overtime policies that exceed federal requirements
- Non-qualifying: Seventh consecutive day overtime (not over 40 hours) or other non-FLSA provisions
Overtime pay required under state or local laws, union agreements, or employer policies does not expand eligibility for this federal deduction and must be excluded from qualified overtime calculations.
Premium pay focus
The deduction applies only to the overtime premium portion of pay, the additional 0.5x regular rate, and does not apply to the regular-rate portion of overtime compensation. To illustrate how this could work, let’s look at an example:
If an employee’s regular rate is $20/hour and they work 50 hours:
- Regular pay: 40 hours × $20 = $800
- Overtime pay: 10 hours × $30 ($20 + $10 premium) = $300
- Deduction applies only to tax withheld from the $100 premium portion (10 hours × $10)
Even when double overtime is paid, only the 0.5x FLSA overtime premium portion qualifies for the deduction — any additional premium above that amount does not apply.
What tax qualifies for the deduction
The deduction is specifically limited to federal income tax withheld from overtime premium compensation.
Eligible for deduction
- Federal Income Tax (FIT) withheld from overtime premium pay only
Not eligible for deduction
- Social Security and Medicare taxes
- State and local income taxes
- Federal income tax withheld from regular wages or the regular-rate portion of overtime
- Any other payroll taxes or deductions
With many headlines making waves about no tax on overtime, employers may be wondering the following.
Should employers continue withholding taxes for overtime?
The answer is yes, employers need to continue withholding federal income tax on all overtime earnings. Payroll taxes are unchanged as Social Security and Medicare taxes (7.65% each) still apply to all overtime earnings. The “no tax on overtime” deduction is then taken by the employee on their individual income tax return, Form 1040.
New reporting requirements
Employers must now track and report overtime premium pay separately to enable employees to claim this deduction.
Form W-2 updates
- Must report eligible overtime premium earnings separately
- Employers will be required to report qualified overtime premium pay separately on Form W-2 so employees can identify the deductible portion of their overtime earnings.
- Required for employees to claim the deduction on their tax returns
If your business operates in states with local overtime laws (such as California’s daily overtime), you must:
- Track FLSA overtime separately from state/local overtime
- Report only the federally-qualified overtime premium for the deduction
- Maintain separate records for different overtime types
System and process considerations
Payroll system updates
- To separately track overtime premium pay and distinguish FLSA from non-FLSA overtime, businesses should consider using payroll with built-in tracking for OBBB-qualified overtime.
- Must distinguish between FLSA and non-FLSA overtime
- Ensure proper reporting on year-end tax forms: Use an end-of-year payroll checklist to review reporting and other filing tasks.
2025 transition note
- Treasury guidance allowed reasonable approximations for the 2025 tax year due to retroactive enactment.
- For 2026 and beyond, employers must precisely track and report qualified FLSA overtime on Form W-2 (Box 12, Code TT) rather than estimating.
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What stays the same
Despite this new deduction, core overtime obligations remain unchanged.
For employers
- Continue calculating overtime at 1.5x regular rate for FLSA purposes
- Maintain existing record-keeping requirements under FLSA
- Pay overtime premiums according to federal and state laws
- Withhold all applicable taxes on overtime earnings
For employees
- Must still work over 40 hours/week to earn overtime premium
- Pay Social Security and Medicare taxes on all overtime earnings
- Follow existing timekeeping and reporting procedures
Future considerations
The federal government is expected to provide additional implementation guidance, including:
- Specific “reasonable methods” for approximating 2025 qualified overtime
- Updated Form W-2 reporting procedures
- Clarification on multi-state employer requirements
- Guidance on tracking overtime premium vs. regular-rate compensation
Action items to consider
- Review current overtime tracking and reporting systems
- Identify any needed upgrades to separate FLSA from non-FLSA overtime
- Prepare for updated Form W-2 requirements
- Monitor Treasury Department announcements for implementation details
Keep an eye on no tax on overtime
While the “no tax on overtime” deduction provides meaningful tax relief for eligible workers through 2028, it introduces new operational complexities for employers. By understanding these requirements and preparing your systems now, you can ensure compliance while helping your employees maximize their tax benefits.
As with many payroll compliance challenges, leveraging modern HR and payroll software can help automate the complex tracking and reporting requirements introduced by this temporary but impactful tax change.
This article is authored by OnPay, a top-rated payroll provider for small businesses with more than 30 years of experience in payroll, taxes, and small business compliance.