What Is the “No Tax on Overtime” Deduction?
Since the One Big Beautiful Bill Act took effect, employees who earn qualified overtime compensation have been able to deduct a portion of that pay on their federal income tax return. The deduction is available whether or not the employee itemizes, but it comes with real limits: up to $12,500 per year for single filers, or $25,000 for married couples filing jointly, and it phases out once modified adjusted gross income exceeds $150,000 ($300,000 for joint filers). According to the IRS, the deduction only covers the “half” portion of time-and-a-half overtime pay that exceeds an employee’s regular rate of pay — not the entire overtime paycheck.
The New Reporting Rule Employers Must Follow in 2026
On August 6, 2026, the IRS issued Fact Sheet FS-2026-13, significantly expanding its guidance on the overtime deduction — and one change matters most for employers. Beginning with tax year 2026, employees generally cannot claim the deduction unless their qualified overtime pay is separately reported on Form W-2, Box 12, using code TT. Employers had transition relief for 2025 wages and were not required to break out overtime pay separately on that year’s W-2s. That relief has ended, and payroll systems now need to track and report the qualified amount correctly for every eligible employee.
What This Means for Payroll
Employers must keep withholding income tax and employment taxes — including Social Security and federal unemployment tax — from all overtime wages, exactly as before. The deduction is claimed by the employee on their own tax return, not applied at the payroll level, and employers should not reduce withholding simply because a worker expects to qualify for it. An employee who wants withholding adjusted for the deduction can submit an updated Form W-4. If a payroll system under-reports the qualified overtime amount, the employee will need a corrected Form W-2c before claiming the full deduction, so accuracy on the front end matters for both the business and its staff.
Who Actually Qualifies for the Deduction
The deduction is tied to overtime required under the Fair Labor Standards Act (FLSA), so it generally applies only to non-exempt employees. The IRS guidance is explicit that several categories of workers are not eligible, including many executive, administrative, professional, outside sales, and computer employees who are FLSA-exempt, along with certain agricultural, transportation, and seasonal workers. Notably, the IRS also clarified that an employee who owns at least a bona fide 20% equity interest in the business and is actively engaged in managing it is not eligible for the deduction — a detail worth knowing if you run a closely held company or professional practice with owner-employees on payroll.
What Houston, The Woodlands, and Denver Employers Should Do Now
If you run payroll for a business — a restaurant in Houston, a service company in the Woodlands, or a growing team in Denver — now is the time to confirm that your payroll system or provider can correctly identify and code qualified overtime under Box 12, Code TT before 2026 W-2s go out early next year. It is also worth reviewing which employees are properly classified as FLSA-exempt versus non-exempt, since that classification now carries a direct tax reporting consequence for the employee, not just a wage-and-hour compliance question for the employer. Getting this wrong does not just create a payroll headache later — it can leave employees unable to claim a deduction they are otherwise entitled to, and it can create correction work for your business once W-2s are already filed.
At Petry Tax & Advisory, we help business owners and the people who run their payroll in Houston, the Woodlands, and Denver stay ahead of mid-year IRS guidance like this — translating new rules into practical payroll and compliance steps before they become a problem. If you have questions about how the new overtime reporting rule affects your business, we would welcome the chance to talk it through in a consultation.
This post is for general informational purposes only and does not constitute legal or tax advice. Consult with a qualified professional about your specific situation.
lucy.petry@petrylawfirm.com
Latest posts by lucy.petry@petrylawfirm.com (see all)
- How Do Employers Report the New “No Tax on Overtime” Deduction in 2026? - August 17, 2026
