Before the One Big Beautiful Bill Act (OBBBA) became law in 2025, overtime income was fully taxable for federal income tax purposes. However, the OBBBA established a new deduction that can offset up to $12,500 of qualified overtime income annually ($25,000 for married couples filing jointly) for the 2025 through 2028 tax years.
If your organization pays overtime to certain employees, it's important to understand how the deduction works. The IRS recently updated its frequently asked questions (FAQs) on this tax break and, as a result, employers may need to update their payroll systems and processes to ensure compliance. Let's review the basic rules and requirements for the deduction, and then dive into the FAQs.
Eligible employees can claim the overtime deduction whether or not they itemize on their federal tax returns. But it doesn't reduce their adjusted gross income (AGI).
Employers and employees should keep in mind that this tax break is a deduction, not an income exclusion. Federal payroll taxes still apply to overtime income — including amounts that are offset by the overtime deduction for federal income tax purposes. And overtime income may still be fully taxable for state and local income tax purposes.
Certain other rules also apply to eligible employees. For example, if married, they must file a joint return to claim the write-off. Also, eligible employees need to have a Social Security number valid for employment that the Social Security Administration issued by the due date of their return, including extensions. The Social Security number must appear on the return claiming the deduction.
The deduction applies only to qualified overtime income, which is defined as extra compensation paid in compliance with the Fair Labor Standards Act (FLSA). The law generally requires time-and-a-half pay for worktime exceeding 40 hours in a workweek. We'll refer to these extra amounts as overtime premiums.
Qualified overtime income doesn't include overtime premiums paid to FLSA-exempt employees, such as executives. It also excludes overtime premiums not required by the FLSA but mandated by state law or under certain contracts (for example, union-negotiated collective bargaining agreements). In other words, the overtime deduction is unavailable to employees who aren't subject to the FLSA's overtime pay requirements.
For instance, let's say one of your employees, Fred, worked 20 hours of overtime in the most recent pay period. Under the FLSA, you paid him $37.50 per hour for overtime compared to his regular hourly rate of $25. In this scenario, Fred's hourly overtime premium is $12.50 ($37.50 – $25), and his qualified overtime income for the period is $250 (20 × $12.50).
The overtime deduction that would otherwise be allowed up to the $12,500/$25,000 limit begins to phase out when an employee's modified AGI (MAGI) exceeds $150,000 ($300,000 for joint filers). In this context, MAGI consists of a taxpayer's regular AGI plus certain tax-free offshore income that typically doesn't apply. The write-off phases out in $100 increments for each $1,000 of MAGI, or a portion thereof, exceeding the applicable threshold.
For example, say your employee Samantha has $20,000 in qualified overtime income from her job with your organization, but her MAGI is $175,000 because of a second job. That's $25,000 above the applicable threshold ($175,000 – $150,000). So, under the phaseout, Samantha's overtime deduction couldn't exceed $10,000 [$12,500 – (25 × $100)].
Or let's say you have an employee named James who's a joint filer with $30,000 of qualified overtime income from your organization. However, his total MAGI is $400,000, which is $100,000 above the applicable threshold ($400,000 – $300,000). Under the phaseout, his overtime deduction couldn't exceed $15,000 [$25,000 – (100 × $100)].
Recent updates to the IRS FAQs on the overtime deduction help clarify the rules. Here are some highlights of the new guidance for employers:
Mandatory reporting requirement. Starting in 2026, employers must separately report qualified overtime income on employees' Forms W-2 using Box 12 and Code TT. Employees can deduct only the qualified income amounts that are reported on their W-2s, which you'll distribute to them in early 2027.
Should you discover an error, you need to issue a Form W-2c to the affected employee as soon as possible. Failure to correct reporting errors promptly may expose your organization to IRS penalties. In addition, if qualified overtime is omitted or understated and you don't provide a corrected W-2, the employee generally can't claim the unreported amount as part of the deduction.
Qualified overtime income calculation. For the deduction's purposes, qualified overtime income generally equals hours worked in excess of 40 during the FLSA-defined workweek × employee's FLSA-mandated regular pay rate × 50%.
Only the overtime premium (the extra 50%) qualifies for the deduction. Put another way, while an employee will generally receive time-and-one-half pay for overtime hours worked, only the overtime premium of one-half of regular hourly pay counts as qualified overtime income. The recently issued FAQs confirm the link between the overtime deduction and existing FLSA rules for:
You may need to update your payroll system to add qualified overtime income data to other information you're already tracking for, say, state law overtime pay compliance, collective bargaining agreements or employer-specific overtime premiums.
FLSA exemptions. The updated IRS guidance reiterates that only FLSA-required overtime premiums can qualify for the overtime deduction. Employees who are exempt from the FLSA overtime rules are ineligible for the overtime deduction — regardless of whether they're eligible for overtime-like payments under employer-specific policies, state law or collective bargaining agreements.
The IRS guidance specifically highlights several common exempt categories. These include executives, administrative personnel, some types of "professional" employees, outside sales personnel, and certain IT and commissioned retail employees. Employee-owners who hold at least a 20% ownership interest and who are actively engaged in management are generally treated as exempt executives. Therefore, they're ineligible for the overtime deduction.
Non-FLSA overtime. The updated guidance clarifies that employers must distinguish between FLSA-required overtime and other overtime payments that employers pay voluntarily or under other legal requirements. For instance, overtime premiums for weekend or holiday work and double-time arrangements may exceed FLSA requirements. When they do, only the amount needed to satisfy the FLSA overtime requirement counts as qualified overtime income. Any excess amount doesn't increase the employee's allowable overtime deduction.
Differences between FLSA-required overtime and state-law overtime requirements may confuse employees and create payroll system challenges for you. For example, some employees may be subject to FLSA overtime pay exemptions that don't have comparable exemptions under state law. You'll need to independently evaluate whether staff members are exempt from overtime under the FLSA even though they may be eligible under state law.
Federal income tax withholding. The FAQs confirm that qualified overtime income remains fully subject to federal income tax withholding. Employers generally can't reduce withholding unless an employee submits an updated Form W-4 that reflects the individual's anticipated overtime deduction.
Consider reminding employees who may be eligible for the overtime deduction to review the accuracy of their current W-4s. Employees who withhold too little could face a larger-than-expected tax bill when they file their returns. Conversely, those who withhold too much risk unnecessarily lowering their take-home pay. The IRS updated the 2026 W-4 to allow employees to account for the overtime deduction.
The updated guidance further cements IRS requirements on how employers must identify, calculate and report qualified overtime income for purposes of the tax deduction in question. You may need to update your payroll systems, processes and specific procedures to comply. Reporting errors may not only trigger penalties, but also frustrate your employees, which could lower morale and productivity. Work closely with your tax advisor to address this important issue and make any necessary adjustments.
Here are some tasks to complete when addressing the rigorous reporting requirements associated with the federal income tax deduction for qualified overtime pay:
Also consider communicating with employees before year end about the new deduction. Remind them that overtime pay remains subject to federal income tax withholding and payroll taxes, as well as that the deduction applies only to qualified overtime premiums. Staff members who expect to claim the deduction may want to review their withholding and, if appropriate, submit an updated Form W-4. Encourage employees with questions about their individual tax situations to consult their Porte Brown tax advisors.
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