No Tax on Overtime: What Small Employers Must Track and Report

From tax year 2025 through 2028, employees can deduct up to $12,500 of qualified overtime pay ($25,000 on a joint return) on their federal income tax return, according to the IRS. For employers, the deduction changes reporting, not paychecks: from 2026, the IRS General Instructions for Forms W-2 and W-3 add box 12, code TT for the total qualified overtime paid, and overtime is still generally subject to income tax withholding, Social Security and Medicare.

What counts as qualified overtime

The IRS defines qualified overtime compensation narrowly. In its questions and answers (FS-2026-01, January 2026):

• Only overtime required by section 7 of the Fair Labor Standards Act (FLSA) qualifies, which is the overtime owed to nonexempt employees for hours over 40 in a workweek.
• Only the premium counts. With time and a half, the “half” qualifies, not the full overtime wage. An employee with a $26.00 regular rate who works 6 overtime hours earns $78.00 of qualified overtime, not $234.00.
• Extra overtime you pay voluntarily doesn’t qualify. If your policy or a state law pays more than the FLSA requires, such as double time, only the FLSA-required portion counts.
• Overtime paid to FLSA-exempt employees doesn’t qualify, even under a collective bargaining agreement.

Our overtime pay calculator shows the FLSA premium separately for each week, including the effect of nondiscretionary bonuses on the regular rate.

Who can claim the deduction

The deduction belongs to the employee, not the business. The IRS fact sheet lists these conditions:

Employees will ask you about it. Point them to IRS.gov or their tax preparer rather than estimating their deduction for them.

What employers must report

Tax year 2025: a transition year

The IRS Q&A says employers were not required to report qualified overtime separately on 2025 Forms W-2, 1099-NEC or 1099-MISC. Some employers chose to show it voluntarily, for example in W-2 box 14, through an online portal or on a separate statement. Employees without that information can use the methods in IRS Notice 2025-69 and the Schedule 1-A instructions.

Tax year 2026 and later: box 12, code TT

The IRS General Instructions for Forms W-2 and W-3 (2026) say: “New box 12, code TT, will be used to report the total amount of qualified overtime compensation.” Two consequences for small employers:

• Report the total qualified amount you paid. The $12,500 and $25,000 limits apply to the employee’s return, not to your W-2.
• Your payroll records have to separate the premium. Total overtime wages aren’t enough; you need the FLSA-required premium per employee for the year.

Withholding and payroll taxes don’t change

The same instructions say overtime compensation is generally subject to federal income tax withholding and to both the employer and employee shares of Social Security and Medicare tax. The deduction is claimed by the employee on the return. It doesn’t make overtime tax-free in payroll.

What to set up in payroll now

1. Confirm each employee’s FLSA status. Only nonexempt employees can have qualified overtime.
2. Pay overtime on the regular rate, including nondiscretionary bonuses. An understated regular rate understates both pay and the code TT amount.
3. Track the premium separately from straight-time pay for overtime hours, per employee and per year.
4. Separate FLSA overtime from extra overtime such as double time or daily overtime required only by state law or your own policy.
5. Ask your payroll provider whether its software reports box 12, code TT for 2026, and test it before year-end.
6. Document the workweek. The Department of Labor defines it as a fixed, recurring 168-hour period, and overtime is counted per workweek, so payroll and timesheets should use the same one.

If your accounting software also handles payroll, check its 2026 reporting before you renew. Our guide to accounting software with job costing covers tools that track labor by job, and the hourly rate calculator shows what overtime does to your labor cost per billable hour.

Frequently asked questions

Is overtime pay tax-free now? Not in payroll. The IRS says overtime is still generally subject to income tax withholding, Social Security and Medicare. Eligible employees can deduct part of it on their federal income tax return for 2025 through 2028.

How much overtime can an employee deduct? Up to $12,500, or $25,000 on a joint return, reduced when modified adjusted gross income exceeds $150,000 ($300,000 for joint filers), according to the IRS.

Does double time qualify for the deduction? Only the part the FLSA requires. The IRS Q&A says overtime paid above the FLSA requirement does not qualify.

Where does qualified overtime go on Form W-2? From tax year 2026, in box 12 with code TT, according to the IRS General Instructions for Forms W-2 and W-3. For 2025, separate reporting was not required.

Do I need to change how I withhold tax on overtime? The IRS instructions say overtime remains generally subject to federal income tax withholding and to Social Security and Medicare tax. Confirm any withholding changes with your payroll provider or tax professional.