Understanding the New Federal Overtime Tax Deduction

What is the new “no tax” on overtime?

The “One Big Beautiful Bill” created a new federal income tax deduction for “qualified overtime compensation.” As clarified in Internal Revenue Service Notice 2025-69, the deduction is far narrower in operation than its title implies—reaching only overtime that is required by the Fair Labor Standards Act (“FLSA”). As such, the Bill’s tax exemption will not apply to all forms of overtime pay, and in many cases does not apply at all.

Who is eligible for this deduction?

The deduction is available only to employees who are entitled to overtime under the FLSA, and only for overtime pay that the Act requires an employer to pay.

How much can taxpayers deduct under this new provision?

Eligible individuals may deduct up to $12,500 per year in qualified overtime compensation, or up to $25,000 for joint filers, subject to income-based phaseouts.

What does “qualified overtime compensation” mean?

Qualified overtime compensation means only the portion of overtime pay that exceeds an employee’s regular rate of pay and is required under Section 7 of the FLSA. The deduction applies to the premium portion of overtime pay, not to the underlying straight-time wages. For example, if an employee making $10/hour works one hour of overtime, their gross compensation for that hour will be $15. However, the employee would only be able to claim the overtime premium ($5) as exempt from taxation.

Does all overtime pay qualify for the deduction?

No. The deduction does not apply to all overtime pay. It applies only to overtime compensation that is required by federal law under the FLSA. Overtime required by a collective bargaining agreement or for any other reason will not ordinarily qualify.

What types of premium pay do not qualify for the deduction?

Premium payments paid for reasons other than satisfying the FLSA overtime requirement, such as double time, holiday pay, or weekend differentials, generally do not qualify. Only the portion of those payments that represents the FLSA-required overtime premium may be deducted.

Do FLSA-exempt employees qualify for this deduction?

No. Overtime compensation paid to employees who are exempt from the FLSA’s overtime requirements does not qualify for the deduction, even if that compensation is mandated by state law or a collective bargaining agreement.

What documentation do employees need to claim this deduction?

Employees will use their Form W-2 to claim qualifying overtime premiums as exempt from taxation. Because 2025 Forms W-2 and 1099 will not separately report qualified overtime compensation, employees must rely on payroll records, pay stubs, or employer-provided documentation that reasonably identifies the FLSA-required overtime premium. The IRS allows reasonable methods to isolate the premium portion of overtime pay.

Will 2026 W-2s require separate reporting of qualified overtime compensation?

Yes. The IRS has indicated that new reporting requirements for FLSA-required overtime are expected to take effect in 2026. Thus, employers must begin to distinctly track FLSA-overtime, even though there may be overlap with overtime required by other sources.

How does the deduction work for employees on a standard 40-hour workweek?

For employees working a traditional 40-hour workweek, the deduction is relatively straightforward. Once an employee works more than 40 hours in a workweek, the FLSA requires overtime pay at one and a half times the regular rate. Only the incremental premium portion of that overtime, generally the additional one-half of the regular rate, qualifies. In practice, this often means that approximately one-third of a standard time-and-a-half overtime payment may be deductible.

How does the deduction apply to firefighters on 24/48 schedules?

Things are not as straight forward for firefighters, who are generally subject to the FLSA’s Section 207(k) work-period rules rather than the 40-hour standard. Under those rules, overtime is not triggered until a firefighter exceeds the maximum hours allowed for the adopted work period. As a result, many hours worked as part of a normal 24-hours-on and 48-hours-off schedule are treated as straight time under federal law and do not generate qualified overtime compensation. Furthermore, many departments have work reduction or Kelly days that decrease FLSA-required overtime. As such, fire departments will need to act carefully in categorizing overtime as required or not required by the FLSA.

How does the deduction apply to police officers?

Police officers, like firefighters, are typically covered by the Section 207(k) work-period rules. Overtime eligibility depends on whether the officer exceeds the maximum hours for the adopted work period, not on a 40-hour workweek. Only overtime compensation that is required under Section 7 of the FLSA qualifies, and only the premium portion of that pay may be deducted. Overtime paid under alternative arrangements, premium schedules, or non-FLSA mandates will not qualify, unless the FLSA requires a premium to be paid.

What steps should employers take to identify qualified overtime compensation?

Employers should conduct a case-by-case analysis of each overtime event to determine whether (and to what extent) the FLSA requires payment of an overtime premium. This inquiry is especially vital for employers with multiple sources of overtime obligations—including the FLSA, collective bargaining agreements, personnel policies, and past practices—that may apply simultaneously to the same hours worked.

When overtime compensation is paid pursuant to multiple sources, only the portion required by the FLSA qualifies for the tax deduction. For example, if a collective bargaining agreement requires time-and-a-half pay for hours that would otherwise qualify only as straight time under the FLSA’s Section 207(k) rules, none of that premium is tax-exempt.

Conversely, if the FLSA requires a premium and the collective bargaining agreement provides for double-time, only the FLSA-required premium (the additional one-half) qualifies for the deduction. Employers should work with their legal and accounting professionals to establish protocols for tracking and documenting the source and amount of FLSA-required overtime premiums separately from other forms of premium pay.

How should 7(g) work be accounted for?

Section 7(g) of the FLSA complicates the situation tremendously. Section 7(g) permits certain employers to pay an employee overtime compensation at one and one-half times a different hourly rate, normally for the performance of out-of-scope work duties. However, work done in a 7(g) capacity counts against an employee’s regular overtime threshold. Furthermore, 7(g) rates are usually lower than an employee’s regular rate of pay. Therefore, care must be taken to track an employee’s 7(g) time and earnings, since they can influence reportable overtime compensation.

Does comp time qualify for the deduction?

Yes, but only when it is cashed out. When a public employer grants comp time in lieu of cash overtime, the employee receives no “overtime compensation” at the time the work is performed. Because the deduction applies only to overtime that is actually paid, the accrual of comp time produces no deductible amount. If comp time is later liquidated, only the portion of that payment representing the FLSA-required overtime premium may qualify for deduction. The straight-time component remains fully taxable. As a result, employees who primarily receive comp time may see little or no benefit from the new provision, and any later payout will require employers to identify which portion, if any, reflects FLSA-required overtime.

What should I do if I have questions about whether my overtime qualifies?

Because eligibility for the deduction depends on both FLSA status and how overtime is paid and documented, employees and employers should review their pay practices carefully. Anyone with questions about whether overtime compensation qualifies, or whether payroll records support the deduction, should consult their attorney or accounting professional for guidance.