The phrase "no tax on overtime" has received plenty of attention since the One Big Beautiful Bill Act became law in 2025. For employees who regularly work overtime, the new federal tax deduction could provide some welcome relief.
For employers, however, the rules introduce a different set of considerations.
The IRS recently updated its guidance on the overtime deduction, clarifying which payments qualify, how those amounts should be calculated and what businesses need to report on employees' tax forms. While the deduction is claimed by employees on their individual returns, employers are responsible for providing the information needed to support it.
And that's where payroll can become a little more complicated.
One of the most important distinctions is that the new deduction applies only to qualified overtime compensation required under the Fair Labor Standards Act (FLSA).
Under the FLSA, eligible employees generally receive time-and-a-half pay for hours worked beyond 40 in a workweek. However, only the additional half of their regular pay rate qualifies for the deduction, rather than the entire overtime payment.
Consider an employee who earns $25 per hour and receives $37.50 for each overtime hour. Although the employee receives $37.50, only the additional $12.50 represents qualified overtime compensation. If that employee works 20 overtime hours, the qualifying amount would be $250.
For the 2025 through 2028 tax years, eligible individuals may deduct up to $12,500 annually, while married couples filing jointly may deduct up to $25,000. The deduction begins to phase out when modified adjusted gross income exceeds $150,000 for individuals or $300,000 for joint filers.
Employees can claim the deduction whether or not they itemize, but the benefit doesn't eliminate federal payroll taxes or automatically reduce income tax withholding. State and local income taxes may still apply as well.
Businesses may have several different reasons for paying employees more than their regular hourly rate. Weekend shifts, holiday schedules, collective bargaining agreements and company policies can all create additional compensation.
Those payments aren't necessarily eligible for the federal overtime deduction.
The IRS has clarified that the qualifying amount must be tied to overtime required by the FLSA. For example, an employer might voluntarily pay double time for certain shifts, but the portion exceeding the FLSA-required premium doesn't increase the employee's deduction.
Similarly, employees who are exempt from federal overtime requirements generally cannot claim the deduction, even if their employer provides additional compensation for working longer hours.
This includes many executive, administrative and professional employees, along with certain other exempt positions.
For businesses with different employee classifications, compensation arrangements or state-specific overtime requirements, determining what qualifies may require a closer look at how payroll is currently calculated.
The biggest operational change involves reporting.
Beginning with the 2026 tax year, employers must separately report qualified overtime compensation on employees' Forms W-2 using Box 12, Code TT.
That means payroll systems need to distinguish between total overtime compensation and the portion eligible for the federal deduction.
A business that currently tracks overtime as one combined amount may need to adjust its payroll processes to capture the qualifying premium separately. Employers should also verify that their calculations reflect applicable FLSA rules, including how workweeks, hours worked and regular rates of pay are determined.
Accurate reporting matters because employees generally rely on the qualified overtime amounts reported on their W-2s when claiming the deduction.
If an employer discovers an error, a corrected Form W-2c may be necessary. Failing to address reporting mistakes promptly can create compliance concerns for the business and potentially prevent employees from claiming the full deduction they're entitled to receive.
Another potential source of confusion involves withholding.
Employees may assume that because qualified overtime compensation is deductible, their overtime paychecks should automatically have less federal income tax withheld.
That's not how the deduction works.
Qualified overtime remains subject to federal income tax withholding during the year. Employees who want their withholding to reflect an anticipated deduction generally need to submit an updated Form W-4.
The IRS revised the 2026 Form W-4 to account for the new overtime deduction, giving eligible employees a way to adjust their withholding based on their circumstances.
Employers don't need to calculate each employee's personal deduction or determine whether their household income exceeds the phaseout thresholds. However, communicating the distinction between a deduction and tax-free wages can help prevent confusion.
It may also be worthwhile to remind employees that changing withholding requires some consideration. Withholding too little can result in an unexpected tax bill, while withholding too much can reduce take-home pay unnecessarily throughout the year.
For employers, the overtime deduction introduces additional reporting responsibilities without fundamentally changing how overtime wages are taxed through payroll.
That distinction is important.
Businesses still need to follow existing wage and hour requirements, withhold applicable taxes and accurately calculate overtime compensation. The new responsibility is identifying which portion of those payments qualifies for the employee's federal deduction and making sure that information is properly reported.
Before year-end, employers should review how their payroll systems classify overtime, confirm that eligible compensation is being tracked separately and determine whether any reporting adjustments are needed.
The deduction may ultimately benefit employees, but the accuracy of the information supporting it begins with the employer.
SSB can help businesses review the tax implications of the new rules, evaluate payroll reporting requirements and prepare for the changes affecting 2026 Forms W-2.
Disclaimer: This content is for informational purposes only and does not constitute tax or legal advice. Consult your tax or legal advisor for guidance specific to your situation.
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