The “No Tax on Overtime” Deduction Explained

Key Points

Eligibility: Must be a non-exempt employee under the FLSA, generally earning less than $150,000 (single) or $300,000 (joint) MAGI to receive the full deduction. The deduction is available for both itemizing and non-itemizing taxpayers.
Qualified overtime: Only pay required by the FLSA (hours over 40 in a workweek) qualifies. The deduction is technically on the premium portion (the “half” in time and a half).
Limitations: The deduction phases out for higher earners and is not available to married couples filing separately.
Tax Impact: This is a federal income tax deduction, not an exemption from payroll taxes (Social Security/Medicare).
Duration: The provision is active for tax years 2025 through 2028.

The IRS recently released Fact Sheet 2026-01, answering questions about the new deduction for qualified overtime compensation, created under the One Big Beautiful Bill Act (OBBBA). The deduction applies for tax years 2025 through 2028 and may benefit certain employees who receive overtime pay.

If an employee earns overtime pay, this could mean some savings on their federal income taxes, but there are important details to understand. Shelley Meier, Senior Accountant II on Grimbleby Coleman’s Client Accounting Services team, has summarized what employees and employers actually need to know.

Overview of the Deduction

The new law allows eligible workers to claim an above-the-line federal income tax deduction on their personal tax return for qualified overtime compensation. “Above-the-line” means the deduction reduces taxable income whether or not the taxpayer itemizes.

However, this change does not alter how overtime is calculated or paid under labor laws. It does not reduce payroll taxes. It does not change withholding. Social Security and Medicare taxes still apply, and wages are reported as usual.

This is strictly a federal income tax deduction claimed on the employee’s individual return. This deduction affects income taxes only and does not change how overtime must be calculated or paid under labor laws, nor does it affect payroll tax obligations.

What Counts as Qualified Overtime?

According to IRS guidance, qualified overtime compensation includes only the portion of overtime pay that exceeds the employee’s regular rate of pay and is required under Section 7 of the Fair Labor Standards Act (FLSA).

The FLSA overtime rules are for hours worked over 40 hours per week, regardless of hours in a day, paid at time and a half. FLSA does not recognize double-time pay. See Example #2.

In a typical “time and a half” scenario, only the additional one-half premium qualifies for the deduction.
The full overtime wage (including the regular rate portion) is not deductible.
Overtime paid solely under state law, a collective bargaining agreement, or employer policy — if not required by the FLSA — does not increase the deductible amount.

Who May Be Eligible?

Workers who are covered by and not exempt from the FLSA overtime requirements
Workers who earn overtime as allowed under FLSA
Workers who use a valid Social Security Number on their tax return
Married individuals must file Married Filing Jointly (not Married Filing Separately)
Individuals eligible for overtime under the FLSA generally must receive overtime pay for hours worked in excess of 40 in a workweek at a rate not less than one and one-half times their regular rate of pay.

Deduction Limits and Phaseouts

The deduction is subject to:

Annual dollar limits ($12,500 per return; $25,000 for joint filers), and
Income phaseouts based on modified adjusted gross income.

These statutory limits may reduce or eliminate the benefit for higher-income taxpayers.

Reporting and Compliance

This deduction does not change how wages are treated for employment tax purposes.
It also does not reduce wages subject to:
- Federal income tax withholding
- Social Security tax
- Medicare tax

For Tax Year 2025:

Employers are not required to separately report qualified overtime compensation on Forms W2 or 1099.
The IRS has provided penalty relief for employers unable to comply with new reporting requirements for 2025.

For Tax Year 2026 and Beyond:

Employers will need to report the qualified overtime in Box 12 on Form W2 using code TT.
Employers should not recharacterize wages or modify payroll tax calculations.
Payroll and HR teams should begin planning now for:
- Accurate identification of FLSA overtime eligible employees
- System-level tracking of the overtime premium portion

Calculating the Qualified Overtime Deduction

EXAMPLE #1

Facts

Employee is non-exempt and overtime eligible under the FLSA.
Regular hourly rate is $20 per hour.
Overtime rate required under the FLSA is $30 per hour (time and a half).
Overtime hours worked during the year is 200 hours.
Employee otherwise meets the income limitations for the deduction.

Step 1: Identify total overtime pay.

The employee is paid $30 per hour for 200 overtime hours:

Total overtime pay received:
$30 × 200 = $6,000

Step 2: Determine the regular rate portion of overtime pay.

The regular rate portion is the employee’s base hourly wage:

Regular rate portion:
$20 × 200 = $4,000

Step 3: Calculate qualified overtime compensation.

Under IRS guidance, only the portion of overtime pay that exceeds the regular rate and is required by the FLSA qualifies for the deduction. In a time and a half arrangement, this is the additional one-half premium.

Qualified overtime compensation:
$6,000 total overtime pay − $4,000 regular rate portion = $2,000 qualified overtime

FLSA Overtime Premium Within California Overtime

EXAMPLE #2

Facts (one workweek):

Regular rate per hour: $20; time and a half: $30; double time: $40
Hours: 40 regular, 10 time and a half, 5 double time
Employee is non-exempt (FLSA overtime eligible)
2025 transition year (employee will use pay stub totals to compute the deductible amount)

Step 1: Total wages paid (for payroll/withholding)

Regular: 40 × $20 = $800
Time and a half: 10 × $30 = $300
Double time: 5 × $40 = $200
Total weekly pay = $1,300 (all reported as wages)

Step 2: Identify qualified overtime compensation (FLSA required premium only)

Total overtime hours under FLSA: 55 − 40 = 15 hours
FLSA premium per overtime hour: $30 − $20 = $10 (the “extra half”)

Even for the 5 hours paid at double time under California law, the FLSA required portion remains 0.5 × regular rate = $10/hour. California’s extra premium does not add to the deduction; it’s simply nonqualifying excess pay over the FLSA minimum.

Qualified Overtime Compensation:
15 hours × $10 = $150 (the deduction is taken on the individual return)

Under the FLSA, all hours over 40 in a workweek are overtime hours and must be paid at not less than time and a half. For purposes of the new deduction, the qualified overtime compensation is the FLSA required premium portion, the amount above the regular rate, even if the employer pays more than FLSA requires (such as double time under California law).

In other words, for each hour over 40, the deductible piece is still an extra 0.5 × regular rate; paying double time does not increase the deductible amount, but it also does not eliminate the FLSA premium embedded in those hours

Tracking Qualified Overtime with QuickBooks

Many payroll platforms are still adapting to this change. In QuickBooks, for example, tracking depends heavily on how pay items are structured. In some cases, manual adjustments may be necessary to maintain accurate year-to-date totals.

There is currently no impact on net pay, and tracking does not necessarily appear on pay stubs. Additional system updates are expected, but employers should not assume automation will be seamless in the early years of implementation.

Intuit has published instructions for tracking overtime within QuickBooks Payroll to assist in calculating qualified overtime.

Get in Touch

For eligible employees, this provision could provide meaningful federal income tax savings. For employers, the larger issue will be tracking and reporting compliance. The opportunity is real — but so are the technical details.

If you pay/your employees regularly earn overtime, it may be worth reviewing payroll systems now to ensure the premium portion can be identified accurately before reporting requirements expand in 2026. We can be a resource to your team. Reach out to your Grimbleby Coleman advisor or contact our team to find out how we can help.

FAQs

The “No Tax on Overtime” deduction is a temporary federal income tax deduction available for tax years 2025 through 2028. It allows eligible employees to deduct the premium portion of federally required overtime pay. It reduces taxable income but does not eliminate payroll taxes or change how overtime is paid.

No. Only the premium portion of overtime pay — typically the extra 0.5 times the regular rate in a time and a half calculation — qualifies. The regular hourly portion of overtime remains fully taxable.

Non-exempt employees covered by the Fair Labor Standards Act (FLSA) who work more than 40 hours in a workweek may qualify. A valid Social Security number is required, and married taxpayers must file jointly. The deduction is not available for married filing separately.

Yes. The maximum deduction is $12,500 per return or $25,000 for joint filers. The benefit phases out at higher modified adjusted gross income (MAGI) levels.

No. The deduction only reduces federal income tax. Overtime wages remain fully subject to Social Security, Medicare, and withholding taxes.

No. The deduction applies only to the federally required overtime premium under the FLSA. Any additional pay required by state law, union contracts, or employer policy does not increase the deductible amount.

For 2025, employers are not required to separately report qualified overtime, and employees may need to calculate it from pay records. Beginning in 2026, employers must report it in Box 12 of Form W-2 using Code TT.