What “No Tax on Overtime” Really Means Under the OBBBA

On July 4, 2025, the One Big Beautiful Bill Act (“OBBBA”) became law. One headline promise was “no tax on overtime” which has generated a lot of interest and a fair amount of confusion. Here is a plain‑English walk through of what changed, what did not, and how to prepare your payroll and records so you (and your team) can claim every dollar you’re entitled to.

Before OBBBA, overtime pay was taxed just like regular wages. Your W‑2 did not break out overtime separately, withholding tables did not make any special adjustment, and both federal income tax and payroll taxes (Social Security and Medicare) applied in the usual way. That general framework still matters for 2025. Withholding and the Form W‑2/1099 series unchanged for this tax year (2025) while the IRS builds the new reporting mechanics. So, what changed?

The new law creates a temporary, above‑the‑line federal income tax deduction for the overtime premium portion of pay that’s required by the Fair Labor Standards Act (FLSA). In other words, the “half” in “time‑and‑a‑half” for hours over 40 in a FLSA‑covered workweek. For 2025–2028, individuals can deduct up to $12,500 of that premium. Married couples filing jointly can deduct up to $25,000. The deduction phases out for higher‑income filers starting at $150,000 of modified AGI (or $300,000 for joint filers), and you can take it whether you itemize or not. To claim the deduction, you must include a valid Social Security number, and if you’re married you must file jointly. The deduction does not remove wages from FICA as Social Security and Medicare still apply.

So, what does this mean? If an employee’s regular rate is $20/hour and the overtime rate is $30/hour, only the $10/hour premium is deductible. If that employee worked 200 hours of qualifying overtime in 2025, the potential deduction is $2,000, which as expected is subject to the overall cap and any phase‑out.

Sounds straight forward, right? Well, it’s complicated. First, “no tax on overtime” does not mean overtime is tax‑free at the paycheck level. For 2025, withholding tables do not change and employees will generally claim the deduction on their 2025 Form 1040 filed in 2026. Expect the IRS to update withholding tables and forms for 2026, but not for 2025. Second, the deduction is limited to the FLSA‑required premium of extra overtime offered by contract, policy, or state rules that go beyond FLSA doesn’t qualify. Finally, “no tax” refers to federal income tax; state and local income taxes and FICA still apply.

Surely all the States conform to Federal tax law, yea? No. For example, California’s daily overtime (after eight hours in a day) and certain seventh‑day rules are more generous than FLSA, but that extra pay is not the FLSA overtime premium the Federal law targets. As a result, daily overtime or double‑time required only by California law generally will not qualify for the Federal deduction unless it also happens to meet the FLSA definition (hours over 40 in the workweek). Separately, California does not automatically conform to every new Federal deduction. Until California acts, assume the federal overtime deduction does not reduce California taxable income. We’ll keep you posted.

At this point you're likely wondering if various types of overtime exist. Well, “Qualified overtime compensation” is the FLSA‑required premium portion paid to non‑exempt workers for hours beyond 40 in a workweek. Overtime voluntarily paid to exempt employees, premium rates above time‑and‑a‑half (say, double‑time for holidays when the week is under 40 hours), or daily overtime that exists only under state law do not fit the Federal definition and therefore do not qualify. A quirk in the statute and early IRS communications mention 1099 reporting in places, but independent contractors generally are not entitled to FLSA overtime. It is here, amidst the confusion and speed of implementation, that the IRS starts to flesh out the reporting process.

For 2025, the IRS is allowing a transition approach, where employers can approximate a separate accounting of qualified overtime by a reasonable method the IRS specifies. In practice, your payroll setup should start tagging the FLSA overtime premium separately from (a) base pay, (b) any daily overtime or double‑time required by state law, and (c) any voluntary or contract premiums. Keep clean weekly time records showing hours over 40, the regular rate calculation (including any nondiscretionary bonuses), and the premium portion paid. Employees should retain year‑end paystubs and employer statements breaking out the qualified amount. Employers should keep the workpapers showing how the qualified portion was computed. Expect 2026 W‑2s/1099s to include explicit boxes or codes for “qualified overtime.”

Two timelines matter here. First, for 2025, withholding tables and wage statements will not change, and the IRS has promised transition relief and reasonable method guidance for tracking this year’s qualified amounts. Second, for 2026 and later years, watch for updated W‑2/1099 instructions and withholding procedures that reflect the new deductions. We’ll circulate an update as soon as the IRS publishes the promised guidance and draft forms.

OBBBA’s “no tax on overtime” is a real, time‑limited federal deduction for the FLSA overtime premium—valuable, but narrower than the sound bite. You’ll maximize the benefit by cleanly separating FLSA overtime from everything else, preserving weekly time records, and preparing for new reporting in 2026. If you operate in California, build your payroll rules to distinguish weekly FLSA overtime from California’s daily overtime, and plan on no California income‑tax benefit unless (and until) the Legislature adopts conformity.