New overtime pay deductions add complexity to tax reporting

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Beginning with 2025 taxes filed in 2026, the IRS will allow a tax deduction for qualified overtime compensation. This new no-tax-on-overtime deduction was introduced in IRC Section 225 as part of the One Big Beautiful Bill Act, or OBBBA. It's available through the 2028 tax year and includes specific rules about eligible overtime categories and income thresholds.

To properly document which overtime pay qualifies, employers must update their reporting and payroll tracking capabilities beginning in 2026.

Who is impacted

Here's a brief explanation of the deduction and its potential impact on employees and businesses.

How are employees impacted?

Hourly and other nonexempt employees may qualify to deduct a portion of overtime income earned from January 1, 2025, through December 31, 2028—subject to the limits in the table below. Only the premium portion of overtime income as defined under the Fair Labor Standards Act, or FLSA, is eligible.

In practical terms, this means only the amount that exceeds an employee's regular rate of pay—the additional half in time-and-a-half compensation—qualifies for the overtime deduction. It also means the deduction applies only to overtime mandated by the FLSA. Overtime mandated by state laws or paid under negotiated agreements doesn't qualify.

Other types of overtime income are also excluded. This includes extra holiday pay, overtime calculated daily rather than weekly and overtime income from certain industries, such as those subject to the Railway Labor Act.

What are income limits for the overtime tax deduction?

The deduction phases out for individuals whose modified adjusted gross income, or MAGI, exceeds $150,000 per year for single filers and $300,000 for married couples filing jointly. For every $1,000 above the MAGI limit, the allowable deduction is reduced by $100. Keep in mind that married taxpayers who file separately aren't eligible for the deduction.

How are employers impacted?

The new no-tax-on-overtime deduction introduces a substantial reporting obligation for employers, who must supply detailed information to help employees document their claims. Over the next 4 years, employers will need to track all qualified overtime pay and provide employees with separate overtime earnings records.

Because providing this information on each worker's W-2 form may require updates to automated payroll and reporting systems, the IRS is allowing alternative reporting methods for the 2025 tax year without penalty. For example, employers can share qualifying overtime details through an online portal or supplemental written statements.

Discuss with your tax advisors how these changes can affect your reporting obligations.

What action is required and when

To ensure compliance with the new overtime pay deduction rules, both employers and employees must take specific steps to adapt their reporting and documentation processes starting in 2026.

Actions for employers

Automated processes may still be unavailable in early 2026, so employers will need to devote resources to identify and communicate qualifying overtime pay for 2025.

Advisors recommend not reporting overtime pay separately on Form W-2 for 2025 or in box 14 because this could cause exposure to litigation under IRC § 7434 for providing an incorrect amount—which could also subject employers to penalties.

For 2025, the IRS encourages employers to provide details on overtime compensation through alternative methods—such as an online portal or supplemental written communications—but not on Form W-2.

As noted in its November 2025 news release, the IRS won't penalize employers for not reporting this information on Form W-2 for the 2025 tax year.

In subsequent years, reporting accurate qualified overtime on Form W-2 becomes mandatory, and employers must update their payroll systems to track and identify the portion of overtime that meets the criteria for this deduction. To support this transition, the IRS has released a draft of the 2026 Form W-2 that includes new codes for reporting qualified overtime pay.

Actions for employees

Employees should save all payroll communications received from their employers during the 2025 reporting transition period to ensure they have the documentation needed to claim the deduction in the first year. For subsequent years, qualified overtime amounts will be reported directly on Form W-2, as required by the IRS.

Who to talk to now

Given the number of tax reforms introduced under the OBBBA, both employees and employers should review the IRS news release that addresses overtime tax deductions to understand how these changes may affect individuals and businesses.

If you're a business owner, reach out to a First Citizens Wealth consultant to discuss how the latest IRS tax changes may influence your employee recruitment and retention programs.