The “One Big Beautiful Bill” (OBBB), signed into law on July 4, 2025, represents the most sweeping tax reform since the Tax Cuts and Jobs Act (TCJA). The bill introduced a headline-grabbing benefit: a tax deduction on overtime pay. But while the idea of “no tax on overtime” has captured attention, the reality is far more nuanced. The new rules don’t apply to all extra hours worked—only a specific kind of overtime qualifies. It is imperative then to explore the key criteria that define eligibility under the law, the distinction between FLSA and non-FLSA overtime, and what employers and employees need to know to stay compliant and capture the benefit.
Background Discussion
Under the OBBB enacted on July 4, 2025, certain overtime wages are now eligible for anabove-the-line federal income tax deduction. This applies to tax years 2025 through 2028, with a deduction cap of $12,500 for single filers and$25,000 for joint filers. The benefit begins to phase out for incomes above $150,000 (or $300,000 jointly).
It’s important to emphasize: this is not a payroll tax exemption. Social Security, Medicare, and state income taxes still apply. The deduction instead reduces adjusted gross income (AGI) on a taxpayer’s Form 1040—meaning the tax benefit is seen when filing the return, not in each paycheck.
Only FLSA Section 7 Overtime Qualifies
The law draws a firm boundary around what kind of overtime qualifies. The only eligible wages are those paid under Section 7 of the Fair Labor Standards Act (FLSA)—the federal law requiring non-exempt employees to receive time-and-a-half for hours worked over 40 in a workweek.
This provision is central to the entire tax benefit. The deduction applies only to the “premium pay” portion—the one-half-times-regular-rate increment of FLSA overtime. In effect, for workers earning time-and-a-half, about one-third of their gross overtime earnings may be deductible.
Overtime That Does Not Qualify
While many employers offer overtime-like pay, most of it falls outside FLSA Section 7 and therefore doesn’t qualify. Here’s what the deduction does not apply to:
1. Voluntary Overtime Programs
Employers may offer double-time pay, weekend premiums, or shift differentials that exceed what FLSA requires. These extra incentives, although generous, are voluntary and not required by Section 7—disqualifying them from the deduction.
2. State-Mandated Overtime Rules
Some states, like California, mandate overtime after 8 hours in a day (not 40 in a week). However, since these rules stem from state law—not FLSA—they fall outside the deduction’s scope.
3. Collective Bargaining and Union Contracts
Many union agreements include built-in overtime requirements. But unless those wages mirror FLSA Section 7 requirements and derive from federal statutory obligations, they won’t qualify.
4. Public-Sector Comp Time
Public employers sometimes offer compensatory time in lieu of overtime pay under specific provisions (e.g., 29 C.F.R. §§ 553.22–.28). Unless these payments directly reflect FLSA Section 7 obligations, they are not eligible.
What Employers Should Know:
Employers must now clearly distinguish FLSA-qualifying overtime from other types of premium compensation. This means:
- Updating payroll systems to flag Section 7 overtime separately.
- Preparing for Form W-2 adjustments—the IRS may issue new Box 12/14 codes or allow approximation methods.
- Training HR and accounting departments to apply the deduction correctly.
Without accurate tracking, companies risk misreporting employee wages, leading to potential audits or disallowed deductions.
The IRS is expected to provide clearer guidance on these rules. When the IRS releases the guidance, we will provide updates! Have questions? Contact your YHB advisor today to discuss how these changes can impact you.
