Last updated: August 20, 2026
The “no tax on overtime” provision in the One Big Beautiful Bill Act (OBBBA) was signed July 4, 2025. It is one of the most widely discussed — and widely misunderstood — payroll changes in years. Most of the confusion comes from the name. Despite what “no tax on overtime” implies, overtime pay is still subject to federal and state income tax withholding, Social Security, and Medicare. The change is a deduction employees claim on their individual tax returns — not a change to payroll processing. However, it does create new employer reporting obligations your payroll setup needs to handle correctly.
Every fact in this post comes directly from the IRS Fact Sheet FS-2025-03 and related IRS guidance.
No Tax on Overtime: What the Law Actually Says
Under Section 70202 of the OBBBA, non-exempt employees who receive FLSA-required overtime pay may deduct the premium portion of that overtime from their federal taxable income. The Fair Labor Standards Act requires time-and-a-half for all hours over 40 in a workweek — and only that FLSA-mandated overtime qualifies for this deduction. The deduction applies to tax years 2025 through 2028 and is retroactive to January 1, 2025.
Three things are critical to understand about how this works:
- Only the premium portion qualifies. The deduction applies to the “half” portion of time-and-a-half — the extra 0.5x above the regular rate. If your employee earns $20/hour and receives $30/hour for overtime, only the $10 premium qualifies. The regular hourly portion of overtime pay does not qualify.
- Only FLSA-required overtime qualifies. This is the most commonly missed point. Overtime paid voluntarily — holiday pay, weekend pay — does not qualify. Contractual overtime where total hours don’t exceed 40 in the workweek also doesn’t qualify. Only overtime legally required under the federal FLSA counts.
- Employees claim it on their tax return — not through payroll. Federal income tax withholding on overtime has not changed. Employers still withhold at the regular rate. Employees claim the deduction when they file their federal individual income tax return for 2025 and forward.
Who Is Eligible for the No Tax on Overtime Deduction
To claim the no tax on overtime deduction, an employee must meet all of the following criteria. Furthermore, all conditions must apply simultaneously — meeting some but not all disqualifies the employee from the deduction:
- Non-exempt status under FLSA. Salaried exempt employees do not receive FLSA-required overtime and are not eligible. The deduction applies to hourly non-exempt workers who receive time-and-a-half for hours over 40.
- MAGI under $150,000 (single) or $300,000 (joint). The deduction phases out above these thresholds. High-earning employees who happen to be non-exempt are unlikely to benefit.
- Maximum deduction: $12,500 single / $25,000 married filing jointly. The premium portion eligible for the deduction is capped annually.
Additionally, two filing requirements apply:
- Must include Social Security Number on the return. Married taxpayers must file jointly to claim the deduction.
- Available to both itemizers and non-itemizers. The deduction is an “above-the-line” deduction — it reduces adjusted gross income even for employees who take the standard deduction.
What This Means for Your Payroll: Employer Obligations
The no tax on overtime provision creates new employer obligations your payroll setup must handle. Specifically, the IRS requires employers to separately identify and report FLSA-required overtime compensation paid to each employee.
Reporting Requirement: Track FLSA Overtime Separately
Employers must file information returns with the IRS and furnish statements to employees showing the total amount of qualified overtime compensation paid during the year. This means your payroll system needs to distinguish between:
- FLSA-required overtime (hours over 40 in a workweek, at 1.5x the regular rate) — qualifies
- Voluntary overtime premium pay (holiday pay, weekend pay, contractual overtime not triggered by the 40-hour FLSA threshold) — does not qualify
- Regular hourly wages for overtime hours — does not qualify (only the 0.5x premium qualifies)
If your payroll system currently tracks overtime as a single earnings code without distinguishing the source, that setup needs to be reviewed. Specifically, a system that can’t separate FLSA-required overtime from other premium pay can’t produce accurate qualified overtime compensation figures for employee reporting.
2025 Transition Relief: IRS Notice 2025-69
The IRS issued Notice 2025-69 in November 2025, providing transition relief for the 2025 tax year. Under this guidance, employers are not required to separately report qualified overtime compensation on 2025 W-2s. However, employees are responsible for determining their own qualified overtime amounts for 2025 using their pay stubs. For 2026 and forward, employer reporting requirements are expected to apply in full. Additionally, the IRS has indicated it will issue further guidance on the reporting mechanics.
Additionally, federal income tax withholding rates on overtime have not changed for 2025. Employers should continue withholding at the applicable rate on all overtime compensation. Employees adjust their taxable income when they file.
Illinois and Wisconsin State Tax Treatment
The no tax on overtime deduction is a federal provision only. Illinois and Wisconsin have not adopted corresponding state-level deductions. As a result, overtime pay remains fully subject to Illinois income tax withholding (4.95% flat rate) and Wisconsin income tax withholding (graduated brackets). Employers should not reduce state income tax withholding on overtime pay based on the federal deduction.
This is a point of confusion for many employees. Specifically, employees who see their federal tax bill reduced through the deduction will not see a corresponding reduction in Illinois or Wisconsin state tax. Make sure your HR and payroll communications address this gap so employee expectations are set correctly before tax season.
No Tax on Overtime: What Your Employees Are Asking
Since the OBBBA passed, employers across Illinois and Wisconsin have been fielding employee questions. Here are the most common — with accurate answers sourced directly from IRS guidance.
Will my paycheck get bigger because of no tax on overtime?
Not automatically. Federal income tax withholding on overtime has not changed. Your paycheck will look the same. Instead, the benefit comes when you file your federal tax return — you deduct the eligible portion of overtime premium pay from your taxable income at that point, which reduces your tax liability or increases your refund.
Does this apply to all overtime or just some of it?
Only the premium portion of FLSA-required overtime qualifies. Specifically, if you earn $20/hour and receive $30/hour for overtime, only the $10 premium per overtime hour counts toward the deduction. Additionally, only overtime triggered by working more than 40 hours in a workweek under the FLSA qualifies. Extra pay for working holidays or weekends where you didn’t exceed 40 hours does not qualify.
Is there a limit to how much overtime pay is tax-free?
Yes. The maximum annual deduction is $12,500 for single filers and $25,000 for married filing jointly. Furthermore, the deduction phases out entirely for individuals with MAGI over $150,000 ($300,000 joint). High earners in non-exempt hourly roles — a relatively uncommon combination — may receive little or no benefit.
Do I need to do anything different at work to get this deduction?
For 2025, employees are responsible for identifying their own qualified overtime amounts from their pay stubs. Divide total overtime pay by 3 to estimate the premium portion. Starting with 2026, employer reporting is expected to make this easier — payroll systems will be required to track and report qualified overtime compensation separately. However, the IRS has not finalized all reporting mechanics as of the date of this post. Therefore, employees should consult a tax advisor for guidance specific to their situation.
What This Means for Your Business
The no tax on overtime provision doesn’t change how you process payroll or withhold taxes on overtime. However, it does change the data your payroll system needs to track — specifically, the separation of FLSA-required overtime from other premium pay — and the information you’ll need to provide to employees for their tax filings.
If your current payroll setup doesn’t distinguish FLSA-required overtime from voluntary premium pay, or if you pay overtime in industries with complex compensation structures (restaurants, contractors, medical practices, salons), now is the time to review your earnings code configuration. In particular, a payroll provider who understands the OBBBA implications for your industry can help you set this up correctly before the 2026 reporting requirements take full effect.
For the tax side of this provision — how it interacts with owner compensation strategy, S-Corp elections, and year-end planning — our sister firm Accounting Freedom covers the employer tax planning implications: see their Learning Center here.
Ready to Review Your Overtime Tracking Setup?
Questions about how your current payroll setup handles overtime tracking? Our 30-minute meeting is the place to start. Or use our pricing calculator to see what a properly configured payroll setup costs for your employee count.
Illinois: 847-949-8373 | Wisconsin: 262-375-2440
Frank Fiore is the President and Visionary of Payroll Freedom, a local payroll and HR services firm serving small businesses in Illinois and Wisconsin since 1981. As a CPA and payroll specialist with more than 20 years of experience, Frank helps small business owners navigate federal and state payroll compliance changes — including major legislative changes like the One Big Beautiful Bill Act. This article is provided for general informational purposes only and does not constitute legal, tax, payroll, or HR advice. All facts are sourced from IRS Fact Sheet FS-2025-03 and related IRS guidance current as of the date of this post. The no tax on overtime provision and related employer reporting requirements are subject to additional IRS guidance and regulatory changes. Before acting on anything you read here, please consult with a qualified tax advisor or CPA. Reach out to Payroll Freedom for payroll configuration guidance specific to your business, or Accounting Freedom for tax planning guidance.
