Overtime Tax Deduction Explained: What Employers Need to Know, and How to Track It

The new “One Big Beautiful Bill” brings significant changes to how overtime pay is treated for federal taxes. For tax years 2025 through 2028, eligible workers can deduct part of their overtime–the additional pay above their regular hourly rate–from their federal taxable income. This tax break is designed to reward employees who put in extra hours while reducing their overall tax burden. For more information, click here. 

What Does the One Big Beautiful Bill Do?

•  What Qualifies: Only the overtime premium defined by the federal Fair Labor Standards Act (FLSA): the extra 0.5x hourly pay for hours worked beyond 40 in a week.
• Type of Deduction: Above-the-line, meaning all taxpayers can claim it, even if they don’t itemize.
• Who Qualifies: Workers earning less than $150,000 (single) or $300,000 (married filing jointly).
• Deduction Limit: Up to $12,500 (individuals) or $25,000 (joint filers).

Why Was the Overtime Tax Deduction Introduced?

The Overtime Tax Deduction was introduced to provide financial relief to workers who put in extra hours and help employers maintain workforce flexibility without overburdening payroll costs. Lawmakers designed this provision as part of the broader “One Big Beautiful Bill” to reward productivity, ease inflationary pressures, and support middle-income earners.

By allowing employees to deduct the overtime premium portion (the extra half-time rate required by FLSA), this tax benefit helps reduce taxable income for those working beyond 40 hours a week. For employers, this legislation brings new compliance responsibilities, particularly in differentiating between federal and state overtime and ensuring accurate reporting to the IRS.

Why Employers Need to Pay Attention

The law requires employers to track and report FLSA overtime separately on employees’ Form W-2.

This is a new layer of complexity, particularly in states like California, Alaska, Colorado, and Nevada, where state laws mandate additional overtime premiums (e.g., for hours beyond 8 in a day).

• Only the portion required by FLSA qualifies

• State-specific overtime does not qualify

• Union or other contractually negotiated overtime does not qualify

• Employers must now distinguish between federal and state overtime.

How the Overtime Tax Deduction Works: Simulated Examples

Example 1: Standard Federal Overtime

• Regular rate: $20/hour
• Hours worked: 45
• Qualified Overtime: 5 hours × $10 (0.5 × $20) = $50
• Deduction applies to $50 (FLSA overtime).

Example 2: California Daily Overtime

California has stricter definitions for overtime than the federal standard, including 1.5× pay for hours over 8 per day or 40 per week:

• Regular rate: $20/hour
•  Hours worked: 9 hours/day for 5 days
• California requires overtime after 8 hours/day.
• Federal FLSA requires overtime only after 40 hours/week.
• The extra 5 daily overtime hours (beyond 40 total) may be split between state-only and federal portions.
• Only the portion meeting the federal rule is deductible.
• Deduction applies to $10 (1 hour × $10 (0.5 × $20) = $10).

Example 3: California Overtime with Double Time

California also requires 2× pay for hours worked over 12 per day.

Timesheet Example

• On Tuesday, the employee worked 14 hours, earning:
  •  8 regular hours
  • 4 hours OT-CA (California daily overtime)
  • 2 hours DT-CA (California double time)
  • None of these count for the federal deduction, as they are state-specific premiums.
• On Friday, the employee’s hours pushed the total weekly hours to 44, triggering 4 hours of federally required overtime.
  • These 4 hours (OT-FLSA) qualify for the deduction.

Example 4: Union Contract (37.5-Hour Standard)

Some union contracts define a standard workweek of 37.5 hours, with contractual overtime applying above the FSLA threshold.

• Hours between 37.5 and 40 (labeled OT-Union above) are union contractual overtime, and not deductible.
• Only the 3.5 hours beyond 40 on Friday qualify as OT-FLSA.

Key Dates and Implementation Timeline

To ensure compliance with the "No Tax on Overtime" deduction under the One Big Beautiful Bill Act (H.R. 1), employers and employees should note the following timeline:

• Tax Year 2025: Employees can claim the overtime deduction for qualified FLSA overtime pay (the 0.5x premium for hours over 40 per week) on their 2025 federal tax returns, filed in early 2026. Employers must track qualified overtime pay for 2025 to provide accurate records to employees, as this data will be reported on Form W-2 issued by January 31, 2026. Due to the bill’s mid-year enactment (July 4, 2025), the IRS may allow simplified tracking or estimation for early 2025 overtime, pending further guidance.
• January 31, 2026: Employers must report qualified overtime pay on Form W-2 for the 2025 tax year, using a new box designated under Section 6051(a)(19) of the tax code. Payroll systems should be updated by late 2025 to ensure accurate reporting.
• December 31, 2028: The overtime deduction expires at the end of the 2028 tax year unless Congress extends or modifies the provision. Employers and employees should monitor for updates on potential extensions.

Employers should prepare now by updating payroll and time-tracking systems to distinguish FLSA overtime from other types (e.g., state or union overtime) to meet the 2025 reporting requirements.

Penalties for Non-Compliance

Failure to accurately track and report qualified overtime pay can lead to significant consequences:

• IRS Penalties: Inaccurate or incomplete Form W-2 reporting may result in IRS penalties, ranging from $50 to $310 per incorrect form, depending on the error’s severity and correction timeline (per IRS guidelines for information returns). Intentional disregard could increase penalties significantly, and audits may follow.
• Employee Tax Complications: Incorrect reporting may prevent employees from claiming the full deduction, leading to higher taxable income or IRS adjustments during filing. Employees may need to amend returns, causing delays and additional costs.
• Reputational and Legal Risks: Non-compliance could damage employee trust, particularly if workers miss out on tax benefits due to employer errors. Disputes or legal actions may arise if employees perceive mismanagement of their tax-related data.

To avoid these risks, employers should ensure payroll systems correctly identify and report FLSA-qualified overtime, train HR and payroll teams on the new requirements, and test W-2 data transfers for accuracy.

How Can You Handle This in Your Time System?

The new law makes it critical to separate federal overtime from other overtime types (state, union, or contractual). Ensure that the following is implemented in your time system:

1. Flexible Overtime Tracking

• Validation-Based Tracking – Applies FLSA-specific rules to flag only qualifying OT.
• Computation-Based Tracking – Dynamically calculates the correct premium portion above the regular rate.

2. Automatic Coding with OT-FLSA

• Automatically flags federally qualifying overtime with the OT-FLSA code.
• When payroll data is sent to providers like ADP, this code ensures accurate reporting for IRS compliance.

Employer Compliance Checklist

Use this checklist to prepare your organization for the new reporting requirements:

• Update Time Tracking Systems: Ensure your platform distinguishes between FLSA overtime and other overtime types.
• Apply OT-FLSA Codes: Configure automatic coding for federally qualifying overtime for easy payroll integration.
• Train Payroll and HR Teams: Educate staff on the new rules, eligibility criteria, and reporting processes.
• Validate W-2 Reporting: Test data transfer to ensure Qualified Overtime is accurately reflected for employees.
• Communicate to Employees: Provide clear explanations of the deduction benefit so workers understand how it affects their taxable income.

Additional Questions and Answers About Overtime Tax Deduction

What is the overtime tax deduction, and who qualifies?

The deduction applies to the overtime premium portion of pay (0.5× the regular rate) for hours worked beyond 40 in a week under FLSA rules. Employees earning less than $150,000 (single) or $300,000 (married filing jointly) qualify.

How much overtime can be deducted?

Individuals can deduct up to $12,500 of Qualified Overtime, while joint filers can deduct up to $25,000 for tax years 2025 through 2028.

Does state or union overtime qualify?

No. Only the federal overtime premium required by FLSA qualifies. Overtime mandated by state laws or union contracts does not count toward the deduction.

When do employers have to start reporting Qualified Overtime?

Formal reporting begins January 1, 2026, but employers should begin tracking federal overtime separately in 2025 to provide accurate records to employees.

What systems or tools can help?

Look for time and attendance platforms that support validation-based tracking, automatic coding, and integration with payroll providers for seamless compliance.

Conclusion

The new overtime tax deduction is a significant benefit, but only if employers correctly identify and report qualifying overtime. For overtime in 2025, the employer will be allowed to estimate the deduction themselves. The Qualified Overtime reporting for employers formally starts 1/1/26. Get a head start and prepare yourself for the new Qualified Overtime reporting requirement today. 

With DATABASICS Time, you can handle state, union, and federal overtime rules effortlessly to ensure full compliance.