Overtime Just Got a Tax Break! Here’s What Employers Need to Do

Starting in 2025, employees can deduct the premium portion of their overtime pay — but only if you track and report it correctly. Here's what that means for your payroll team.

What’s the New “No Tax on Overtime” Rule?

The One Big Beautiful Bill (OBBB) includes a new deduction for qualified overtime compensation — and while the deduction benefits employees directly, it’s employers who need to set the stage.

What counts as “qualified overtime compensation”?

Only the premium portion of overtime qualifies for this deduction — that’s the “half” in “time-and-a-half.”

Example:
 If Jane earns $20/hour normally and works 10 hours of overtime at $30/hour, the extra $10/hour (10 x $10 = $100) is what qualifies. That’s the part she can deduct on her taxes.

Who qualifies?

This deduction is available to W-2 employees who:

• Work overtime under the Fair Labor Standards Act (FLSA)
• Receive that pay in wages reported on their W-2
• Have a Modified Adjusted Gross Income (MAGI) under $150,000 ($300,000 for joint filers)

Why This Matters for Payroll and HR Teams

Even though this is a personal tax deduction, it depends entirely on how you report overtime in payroll and W-2s for 2025. Yep! This is retroactive to the beginning of the year.

While this is a deduction on an employee’s personal tax return it does not reduce paycheck taxes. Let’s be super clear:

Overtime is still subject to all normal tax withholdings — Social Security, Medicare, and income tax still apply when you run payroll.

But:
At tax time, employees can deduct the premium portion of their overtime pay on their 1040, reducing their taxable income. It’s similar to deducting student loan interest or educator expenses — the money’s already been taxed, but the deduction helps lower their tax bill when they file.

Watch for employee confusion:
Someone might say, “Why is my overtime still getting taxed?” — and the answer is: Because this is a deduction, not a tax exemption. The tax reduction comes when you file your tax return next year.

But if you don’t track or report anything, employees could miss out — and come knocking on your door asking why.

This is not automatic in most payroll systems yet.

Starting in 2026, the IRS expects payroll systems to natively calculate and separate qualified overtime. For 2025, though, you’ll need to do it manually or estimate it.

Heads-up: The amount must be reported on the W-2 — likely in Box 12 (or a future designated box).

Three Things You Should Do Now

1. Choose a reasonable method to estimate for 2025

Pick a way to calculate the premium portion — such as:

• Overtime hours x average premium rate
• A consistent percentage applied across departments or roles

Even a basic formula is better than skipping it altogether.

2. Coordinate with your payroll provider or software

Ask:

• Can we separate and track qualified overtime today?
• How will this show up on W-2s?
• Will adjustments be possible if IRS updates guidance?

If you're handling payroll internally, start building a workaround.

3. Educate your managers and prep for employee questions

Employees may hear “your overtime is tax-free now!” and assume it’s automatic. Make sure:

• Managers know it’s a personal tax deduction (for your Form 1040), not a tax exclusion
• Your team can explain how you’re tracking it (and why it matters)

This Might Be “One Big Beautiful Bill”—But It’s Still One Big Compliance Task

This rule gives employees a nice tax break, but only if employers do the behind-the-scenes work. If you’re not separating overtime now, it’s time to start.

We can help you get ready for 2025 with:

• Guidance on estimation methods
• Payroll setup support
• W-2 reporting preparation