No tax on overtime: what employers need to track and report

What no tax on overtime means

No tax on overtime is a federal income tax deduction, not an exemption from payroll tax. The One Big Beautiful Bill Act (Public Law 119-21, signed July 4, 2025) added section 225 to the Internal Revenue Code, which lets eligible workers deduct qualified overtime compensation on their federal returns for tax years 2025 through 2028. This summary reflects IRS guidance as of October 2026.

The basics, as the IRS describes them:

• What's deductible: only the pay above the regular rate for overtime required by section 7 of the Fair Labor Standards Act, such as the "half" in time-and-a-half.
• Limit: up to $12,500 a year, or $25,000 on a joint return.
• Phase-out: the limit shrinks by $100 for every $1,000 of modified adjusted gross income above $150,000 ($300,000 joint).
• Who can claim it: workers who receive FLSA-required overtime, whether or not they itemize. They need a valid Social Security number on the return, and married couples must file jointly.
• Years: 2025 through 2028, unless Congress extends it.

What it doesn't do: overtime is still wages. Social Security and Medicare taxes apply to all of it, federal income tax withholding generally still applies, and the deduction only shows up when the employee files. Whether a state follows the deduction for state income tax depends on the state.

What counts as qualified overtime compensation

Qualified overtime compensation is the premium portion of overtime the FLSA requires: half the regular rate, for each hour over 40 in a workweek, for an employee who isn't exempt from FLSA overtime. Overtime pay required only by something other than the FLSA doesn't count.

When an hour is overtime under both state law and the FLSA, such as hour 45 of a 50-hour week in California, the FLSA premium on that hour still qualifies. What doesn't qualify is the state-only part.

A worked example

An employee earns $24 an hour and works 50 hours in one workweek.

• FLSA overtime hours: 50 − 40 = 10.
• Overtime rate: $24 × 1.5 = $36, so pay is 40 × $24 = $960 plus 10 × $36 = $360, for $1,320.
• Qualified overtime compensation: 10 hours × the $12 premium = $120.
• Not qualified: the other $240 of overtime pay (10 hours × $24 straight time).

If that week repeats 48 times in a year, the employee's qualified overtime is 48 × $120 = $5,760, well under the $12,500 cap. The tax saved depends on their bracket; at a 12% marginal rate it's about $690.

Bonuses change the number. If that employee also earns a $100 nondiscretionary bonus in the same week, the regular rate becomes $1,300 ÷ 50 = $26, and the qualified premium becomes 10 × $13 = $130 (see how to calculate overtime).

State rules can make it zero. The same $24-an-hour employee working four 10-hour days in California, without an alternative workweek schedule, earns 8 hours of state daily overtime but works only 40 hours, so there's no FLSA overtime and nothing qualifies. See California overtime rules.

What employers must report

For tax year 2026, employers report the total qualified overtime compensation paid to each employee on Form W-2, in box 12, with code TT. The IRS's 2026 W-2 instructions describe it as only the "half" portion of time-and-a-half compensation, and note that overtime is still generally subject to federal income tax withholding and to Social Security and Medicare taxes.

• Tax year 2025: transition relief (IRS Notice 2025-62) meant employers didn't have to report qualified overtime separately. Employers could give employees the amount voluntarily, for example in W-2 box 14 or a separate statement, and employees without one could use the methods in Notice 2025-69 to work it out.
• Tax year 2026 onward: separate reporting with code TT on the W-2.
• Caps are the employee's problem. You report what you paid; the $12,500 limit and the income phase-out are applied on the employee's return.
• Corrections: an error in code TT is corrected on Form W-2c.

There's a parallel deduction for qualified tips, reported with its own box 12 code (TP); it's a separate calculation.

What employers need to track for no tax on overtime

Box 12 code TT is only as accurate as the hours behind it. For every nonexempt employee and every workweek, you need:

• A fixed FLSA workweek. The same seven-day period every week. Qualified overtime is figured per workweek, never averaged across a pay period, so a biweekly payroll has to split each period into its two workweeks.
• Total hours worked in that workweek. Exact hours, including work before and after scheduled shifts.
• The regular rate for that workweek. Including nondiscretionary bonuses, commissions and shift differentials.
• FLSA overtime kept apart from other overtime. State daily overtime, union-contract overtime and voluntary premiums tracked separately from hours over 40.
• Correct classification. Overtime paid to an exempt employee isn't qualified, so exempt and nonexempt status has to be right.
• Corrections that carry through. If a timesheet is edited after payroll, the year-end total has to reflect it.

Accurate weekly hours matter more now than before. A few minutes moved across the 40-hour line changes the qualified amount, employees rely on the W-2 figure when they file, and a total built from reconstructed or one-sided rounded hours is hard to defend. The FLSA already required records of hours worked each workday and workweek (29 CFR 516.2); now those same records drive a number on every W-2. See FLSA recordkeeping requirements.

Questions employers ask

Three questions come up again and again from owners and payroll staff, plus one about other pay types.

Do employers get a tax break from no tax on overtime?

No. The deduction belongs to the employee. The employer's job is accurate pay and reporting, and its share of payroll taxes on overtime is unchanged.

Does it change payroll withholding?

Not automatically. Keep withholding as usual; an employee who expects a large deduction can adjust their Form W-4.

Do salaried nonexempt and piece-rate employees have qualified overtime?

Yes, if they're owed FLSA overtime. The qualified amount is still half the regular rate for each hour over 40, using the usual regular-rate rules for salaries, piece rates and multiple rates. A salaried nonexempt employee paid $800 for a fixed 40-hour week who works 45 hours has a $20 regular rate, so $50 of qualified overtime (5 hours × $10). The overtime calculator handles the weekly split.

Does a 9/80 or other alternative schedule change anything?

Only through the FLSA workweek. If the schedule is set up so no FLSA workweek goes over 40 hours, there's no FLSA overtime and nothing to report as qualified, even if state law treats some hours as overtime.

How a time clock helps

The hard part of code TT isn't the form; it's trustworthy hours for every FLSA workweek. A time clock that records exact punches, totals them by a fixed workweek and splits regular from overtime hours gives payroll the number it needs; see how to track employee hours for the options. TrackBadges, for example, keeps raw punches unchanged, applies a weekly overtime threshold (and an optional daily one), keeps an edit history and exports approved weeks as CSV. If you also use a daily threshold for California, make sure your payroll setup separates FLSA overtime (over 40 in the week) from state daily overtime, since only the FLSA part is qualified.