No Tax on Overtime: IRS Guidance Sheds Light on New Law

The IRS has started rolling out guidance on the One Big Beautiful Bill Act, which contains the no-tax-on-overtime provision and much more.

Not only is HR 1 vast, but parts of it are retroactive, and that includes the overtime provision, which is found in Section 70202.

The legislation adds a new section to the Internal Revenue Code (IRC) – it’s IRC Section 225. The IRS recently released much-anticipated information, shedding light on the new overtime requirements.  

Here are some key points from the federal law and IRS Fact Sheet 2025-03.

Overtime Tax Deduction

For starters, no tax on overtime refers to federal income tax. That means employees will still owe Social Security tax and Medicare tax — not to mention applicable state and local taxes — on their OT compensation.

Important: Payroll should continue to withhold federal income tax from employees’ overtime pay.

Employers will be required to report annual overtime pay on Form W-2, Wage and Tax Statement. The legislation doesn’t indicate which box employers will use – you should be on the lookout for detailed information on Form W-2 from the IRS.

With the W-2 data in hand, employees will be able to claim a tax deduction when they complete Form 1040, U.S. Individual Income Tax Return.

Notably, the overtime deduction will be available to both itemizers and those who take the standard deduction, the fact sheet explains.

Beyond the W-2 information, an employee will need to include his or her Social Security number (SSN) on Form 1040. Plus, in the case of someone who’s married filing jointly, the tax return must also include his or her spouse’s SSN in order to claim the deduction.

The One Big Beautiful Bill Act sets limits on the tax deduction: $12,500 (or $25,000 if married filing jointly). That amount would phase out when a taxpayer’s modified adjusted gross income (MAGI) exceeds $150,000 (or $300,000 if married filing jointly). Specifically, for each $1,000 by which a taxpayer’s MAGI exceeds those amounts, the deduction will be reduced by $100.

Finally, the new deduction is available for the following tax years: 2025, 2026, 2027 and 2028.

Tax Year 2025 and Beyond

The new law includes a transition rule, applicable to tax year 2025. This transition rule allows employers to “approximate a separate accounting of amounts designated as qualified overtime compensation.” Look for the IRS to provide reasonable methods for taking advantage of this transition rule.

As for tax years 2026, 2027 and 2028, the Big Beautiful Bill calls for a modification of the withholding procedures, so that the OT deduction can be taken into account. So again, watch for details on this from the IRS.

The FLSA Connection

HR 1 uses the Fair Labor Standards Act’s (FLSA’s) definition of overtime, while excluding tips.

According to the FLSA, employees must be paid time-and-a-half their regular rate of pay for hours worked in excess of 40 in a workweek, unless of course they’re exempt from the overtime pay requirements.

In its guidance issued July 14, 2025, the IRS addressed questions Payroll has had regarding what constitutes qualified overtime compensation for purposes of the new federal law.

The fact sheet refers to it as the “half” portion of “time-and-a-half” compensation.

Put another way, it’s 50% of the regular rate of pay – i.e., not the full 150%.

Of note, there’s no mention in the law or in the guidance so far about additional responsibilities for employers that pay an overtime premium that exceeds time-and-a-half the regular rate of pay. But more information could be forthcoming.

Next steps: Employers should check in with their payroll software providers regarding modifying or adding codes to their payroll systems.