No tax on overtime: what it means for small business owners

Published Wednesday 5 August 2026

Table of contents

• What is the no tax on overtime rule?
• Did no tax on overtime pass?
• Is there still a tax on overtime?
• Who does no tax on overtime apply to?
• How does no tax on overtime work in payroll?
• How to calculate the overtime deduction
• What does this mean for small business owners?
• Keep your overtime records in order with Xero
• FAQs on no tax on overtime

Key takeaways

• The no tax on overtime rule lets eligible employees deduct the overtime premium portion from federal taxable income at filing, while overtime wages in the paycheck are still taxed as usual.
• Eligibility typically covers FLSA-covered, non-exempt W-2 employees and is subject to income limits and annual caps under current IRS guidance.
• Employers should track the premium portion of overtime, keep clean records, and help employees understand that withholding for Social Security and Medicare still apply.
• Cloud accounting platforms with payroll integration, connected time-tracking apps, and AI support can streamline overtime tracking, reporting, and employee support while reducing manual admin.

What is the no tax on overtime rule?

No tax on overtime refers to a federal income tax deduction that allows eligible employees to exclude the premium portion of overtime pay from federal taxable income when they file their annual tax return. This means the extra half-rate paid on top of regular wages for overtime hours worked can be deducted from taxable income, reducing the employee's overall federal income tax liability for the year.

As an employer, you need to understand exactly what this rule does and what it does not do. The deduction applies only to federal income tax and is claimed by the employee on their tax return. Overtime wages are still taxed at the paycheck level. When you run payroll, you still withhold federal income tax, Social Security, and Medicare taxes on all overtime pay, just as you would for regular wages.

The overtime premium deduction is part of broader tax policy changes designed to provide relief to workers who put in extra hours. When does no tax on overtime start? The deduction became available for the 2025 tax year, meaning employees can first claim it when they file their 2025 returns in early 2026. Under current law, the deduction ends after the 2028 tax year unless Congress extends it.

For small business owners, your payroll fundamentals stay the same, but you need to prepare for changes. What stays the same: you continue to withhold federal, Social Security, and Medicare taxes on all overtime pay. What changes: you must track and report the overtime premium portion separately so employees have the data they need to claim the deduction when they file. Starting in 2026, you must report this premium portion on employees' W-2s using code TT in Box 12. Additionally, if employees submit updated W-4s in 2026 to account for their estimated overtime deduction, you must implement those withholding changes in your payroll system.

When you understand the no tax on overtime rule in plain terms, you can explain it clearly to your team and keep accurate payroll records.

Did no tax on overtime pass?

Yes, the no tax on overtime provision passed. It was signed into law as part of the One Big Beautiful Bill Act and applies starting with the 2025 tax year.

But it's not a full tax exemption. It's a deduction against the premium (the amount over your regular rate) of qualified overtime compensation, effective for tax years 2025 through 2028. Overtime pay is still subject to FICA taxes, and the non-premium portion of overtime pay is still taxed.

The amount withheld during the pay period depends on whether your employee submits an updated W-4. The 2026 Form W-4 includes a field in Step 4(b) where employees can enter their estimated overtime compensation. If your employee completes this field and submits the updated W-4 to you, you must input it into your payroll system, and the software will recalculate withholding based on that updated form.

Regardless of whether an employee adjusts their W-4, they'll claim the overtime deduction on their federal income tax return and settle up at tax time. Here's how it works: During the year, your payroll software calculates withholding based on the employee's W-4 and assumes similar paychecks throughout the year. If an employee estimates their overtime deduction on their 2026 W-4 Step 4(b), your software will reduce withholding accordingly, and they'll take home more in each paycheck. If they don't adjust their W-4, taxes are withheld as usual. Either way, when they file their return, they calculate the actual overtime premium they earned and claim the deduction. If too much was withheld, they get a refund; if too little, they owe.

The overtime deduction is currently set to expire after the 2028 tax year unless Congress extends it. As an employer, track and report the overtime premium portion so your employees have the accurate data they need to file their returns.

Is there still a tax on overtime?

Yes, overtime pay is still taxed. The "no tax on overtime" rule does not make overtime wages tax-free. It creates a deduction that eligible employees can claim when they file their federal income tax return, which may reduce the amount of federal income tax they owe for the year.

What is the overtime tax rate? There is no special overtime tax rate. Overtime wages are taxed at the employee's regular effective federal income tax rate, the same rate that applies to their other taxable earnings. The common belief that overtime is taxed at a higher rate is a misconception.

What employees often notice is that extra taxes are withheld when a larger paycheck pushes more of their income into a higher tax bracket for that pay period, but their overall tax liability is calculated across the full year when they file. And if too much tax was withheld from a paycheck with a lot of overtime, the employee can get that tax refunded when they file their return.

For many of your employees, the practical benefit of the deduction shows up as a lower tax bill or a larger refund when they file, not necessarily as higher take-home pay during the year.

Who does no tax on overtime apply to?

The overtime premium deduction is designed for a specific group of workers. Eligibility is based on employment status, hours worked, and income thresholds set by the IRS.

In your business, the following types of workers may qualify for the overtime premium deduction:

• Employees covered by the Fair Labor Standards Act (FLSA) who are non-exempt W-2 employees and receive overtime pay under federal law
• Hourly and salaried non-exempt workers who earn overtime pay when they work more than 40 hours in a workweek

But to claim the deduction, employees annual income must fall below the IRS-specified income limits and phase-out thresholds.

Several categories of workers are excluded from the deduction:

• independent contractors and 1099 workers, as they are not classified as employees
• exempt salaried employees (such as executives or people in administrative, and professional roles) who do not receive overtime pay under FLSA rules
• employees whose annual income exceeds the phase-out limits set by the IRS
• employees who do not work overtime hours during the tax year

Income limits and annual caps: The maximum amount an individual can deduct annually is set at $12,500 ($25,000 for joint filers). The deduction begins to phase out for taxpayers once their modified adjusted gross income (MAGI) exceeds $150,000 ($300,000 for joint filers). Who does no tax on overtime apply to in your business? It generally applies to all of your hourly employees and non-exempt salaried employees – in other words, all of your employees who are eligible for mandatory overtime pay.

How does no tax on overtime work in payroll?

How does no tax on overtime work in your day-to-day payroll process? For 2025, your payroll stays the same—you continue to withhold federal income tax, Social Security, and Medicare taxes on all overtime wages as usual. Starting in 2026, if your employees submit updated W-4 forms to account for the overtime deduction, you must implement the new withholding information in your payroll system. Otherwise, payroll remains unchanged.

Your employees claim the deduction when they file their annual federal income tax return. At that point, they calculate the overtime premium portion they earned during the year, subject to the IRS cap and income limits, and deduct it from their taxable income. This reduces their federal income tax liability and may result in a larger refund or lower tax owed.

• What you withhold: By default, when you run payroll, you withhold taxes on the full amount of overtime pay—both the regular rate portion and the premium half-rate. However, if an employee submits an updated 2026 W-4 that accounts for their estimated overtime deduction, you must adjust withholding accordingly. Social Security and Medicare taxes continue to apply to all overtime wages, with no exemption. State income tax withholding also remains unchanged unless your state has adopted a conforming rule.
• What employees claim: After the tax year ends, employees use their W-2, pay stubs, and any supplemental reports you provide to calculate the total overtime premium they earned. They then claim the deduction on their federal return, up to the annual cap and subject to income phase-outs.
• Your role as an employer: You are not required to proactively adjust withholding tables across your entire system, but you must implement individual employee W-4 changes when they submit them. However, for tax years 2026 to 2028, employers are required to separately report qualified overtime compensation on their employees' W-2s. For tax year 2025, the IRS recommended that employers put over-time hours on their employees W-2s but it wasn't required so for that year, you could provide your employees with detailed pay stubs, year-end summaries, or supplemental reports that break out regular pay, overtime hours, and the premium portion.
• Employee communication: Many employees may not fully understand how the deduction works or may expect to see lower taxes in their paychecks or bigger refunds at tax time. Providing a short, clear explainer (either in writing or during a team meeting) can prevent confusion and help your team make informed decisions about withholding and tax planning. But be careful not to provide tax advice and consult with a business attorney if you're unsure about the line between answering general questions about taxes and providing specific tax advice.

Steps for employers to prepare

Use these steps to get payroll and records ready without changing your pay runs:

1. Confirm which roles are non-exempt. Review your employee classifications and identify who is entitled to overtime pay under federal law. Check job descriptions, salary levels, and duties of salaried employees to ensure accurate classification. Misclassified employees can create compliance issues, so verify that your non-exempt workers are properly categorized. All the news around "no tax" on overtime means employees may be watching the rules closer than usual.
2. Map earnings codes so overtime premium can be separated from base pay. Set up or adjust your payroll system to track the premium half-rate separately from the regular rate portion of overtime. Most payroll systems allow you to create custom earnings codes that automatically calculate and display the premium portion. This separation makes it easier to generate reports and provide employees with the data they need for tax filing.
3. Capture hours and rates from time tracking with clear audit trails. Ensure your time-tracking system records overtime hours accurately and links to payroll for accurate calculations. Most digital time-tracking systems timestamp entries and maintain records of edits or approvals. This creates a reliable audit trail that supports both payroll accuracy and compliance documentation.

What to track for accurate records

Here are the specific data points you should track for compliance and employee support.

• Regular rate used to calculate overtime: Document the base hourly rate or salary-derived rate for each employee in each pay period.
• Total overtime hours worked under FLSA rules: Record all hours over 40 in a workweek that qualify for overtime pay.
• Total overtime pay and the premium portion separately: Break out the regular rate portion and the premium half-rate on pay stubs and in your payroll system.
• Dates worked and pay period applied: Maintain a clear record of when overtime was worked and which pay period it was paid in.
• Track employee FLSA status and job classification: Document whether each employee is exempt or non-exempt and update this status when roles change.
• Store source records: timesheets, policy, and pay calculations. Keep copies of timesheets, overtime approval records, and any payroll calculation worksheets for audit purposes.

For detailed guidance on calculating overtime pay, see the Xero guide on over time rules

How to calculate the overtime deduction

The overtime deduction is based on the premium portion of overtime pay – the extra half-rate you pay on top of the regular hourly rate as mandated by the Fair Labor Standards Act (FLSA), which requires overtime for hours worked by non-exempt employees in excess of 40 in a workweek. State-only or contract-based overtime that exceeds FLSA requirements does not qualify as eligible overtime for this deduction.

The basic method: To isolate the premium portion, take the employee's regular hourly rate, multiply it by 0.5, and then multiply that result by the number of FLSA-qualifying overtime hours worked over the entire tax year.

For example, if an employee earns $20 per hour and works 10 hours of overtime in a week, the premium portion is:

$20 x 0.5 x 10 hours = $100

If that employee works overtime consistently throughout the year, you add up the premium portion from each pay period to arrive at the annual total. The employee then claims this total, up to the IRS cap, when they file their return.

Steps to calculate the overtime deduction

Follow this clear, repeatable process you can mirror in reports.

1. Identify the regular rate for each workweek, including nondiscretionary bonuses. For hourly employees, this is typically their base hourly rate but you may also need to include shift differentials and non-discretionary bonuses. For salaried non-exempt employees, divide their weekly salary by the hours it's intended to cover to find their base rate. Include any nondiscretionary bonuses, commissions, or shift premiums earned during the workweek that are requires to be factored into the overtime calculation.
2. Determine FLSA-qualifying overtime hours for each workweek. Count only hours over 40 in a workweek that are required to be paid at overtime rates under federal law. This excludes state-mandated daily overtime, contractual overtime that exceeds federal requirements, and any hours that don't qualify under FLSA standards. Focus specifically on the federal 40-hour workweek threshold.
3. Calculate the premium portion: the extra half-rate multiplied by overtime hours. For each pay period, take the regular rate, multiply by 0.5, and multiply by overtime hours. This gives you the premium amount – the portion above and beyond what the employee would have earned at their regular rate. This is the amount that may be deductible, not the total overtime pay.
4. Sum the premium portion across the year for each employee. Add up the premium amounts from every pay period to get the annual total. Keep detailed records of each calculation, as employees will need this information to claim the deduction.
5. Document calculations and keep backup records with timesheets and pay stubs. Store all source data and calculation worksheets in case of an audit or employee question. This includes the regular rate calculations, overtime hour records, and the premium portion breakdowns. Organize these records so they can be easily retrieved and reviewed.

Edge cases to check

Pay attention to these scenarios that change the regular rate or overtime basis.

• Review salaried non-exempt with fluctuating workweeks. If you use the fluctuating workweek method, the employee's regular rate changes each week, so the premium calculation must be adjusted accordingly.
• Include nondiscretionary bonuses and shift differentials in the regular rate. Bonuses tied to performance, attendance, or productivity must be included in the regular rate before calculating the overtime premium. But you don't have to include discretionary bonuses that you pay to employees at your discretion, like an unexpected holiday bonus.
• Handle piece-rate or commission pay with blended rates. When employees earn piece-rate or commission, calculate a blended regular rate for the workweek and apply the premium to that rate.
• If you pay double time (2x the regular rate), only the premium portion qualifies for the deduction. Count only 0.5 times the employee's regular rate as the deductible premium, not the full double-time premium.
• Exclude state-only or contract-only overtime that is not FLSA-required. Overtime paid under state law (such as daily overtime in California) or contractual agreements that exceed FLSA minimums does not qualify for the federal deduction.
• Verify comp time or on-call arrangements against FLSA rules. Make sure any compensatory time or on-call pay arrangements comply with FLSA before including them in the overtime premium calculation.

For more on overtime pay rules and calculations, see how to calculate overtime.

Simplify overtime tracking with Xero

Managing overtime tracking, premium separation, and W-4 compliance is much easier with cloud payroll software. Xero connects with Gusto payroll (and other payroll providers like QuickBooks Payroll and ADP) so you can automatically track overtime, separate the premium portion, and generate clean reports. When employees submit updated W-4s, you can quickly implement the new withholding instructions in your payroll system—no manual spreadsheets required.

To learn more about Xero's payroll features and integrations, visit the Xero payroll page. Get one month free when you start your trial.

FAQs on no tax on overtime

Here are answers to common employer questions about the overtime premium deduction and how it affects payroll practices.

When does no tax on overtime start and end?

The overtime premium deduction first applies to overtime worked in the 2025 tax year and, under current law, ends after the 2028 tax year unless Congress extends it. You should keep an eye on IRS updates in case these dates change.

What part of overtime pay is deductible?

Only the overtime premium – the extra half of the hourly rate paid for hours over 40 in a workweek – is deductible. You can show employees how this appears on their pay stubs so they can use it at tax time.

Does this change Social Security and Medicare taxes?

Social Security and Medicare taxes still apply to all overtime wages, including the premium portion. You should keep withholding these taxes as normal, because the overtime deduction only affects federal income tax on the employee's return.

Can employers reduce federal withholding on overtime pay?

You should not reduce federal income tax withholding on overtime pay, unless your employees have given you an updated W-4 requesting you to do so. The IRS updated the W-4 withholding form at the end of 2025 to allow employees to request additional withholding based on the overtime deduction.

How will no tax on overtime work in 2026?

In 2026, you don’t need to change how you run payroll, but you should be ready to provide pay stubs and annual W-2 forms that clearly show the overtime premium employees earned so they can claim the deduction when they file their 2026 tax returns.