Signed into law on July 4, 2025, the One Big Beautiful Bill Act includes a major change for many hourly workers: the new “No Tax on Overtime” rule. Starting in 2025, eligible employees may benefit from federal tax relief on certain overtime earnings. However, the new provision also introduces compliance challenges for employers and areas of legal uncertainty that will likely require further regulatory clarification.
Who Qualifies—and Who Doesn’t
The provision is limited to overtime wages paid under Section 7 of the Fair Labor Standards Act of 1938 (FLSA). This means it applies only to non-exempt employees who are entitled to overtime under the FLSA—not to exempt employees, who do not qualify for overtime under the law.
The rule allows eligible employees to deduct FLSA-qualifying overtime wages reported on Form W-2. Importantly, this only includes overtime earned under the FLSA—not overtime granted through employer policies or collective bargaining agreements. Employers must carefully distinguish between these categories.
What About Public-Sector Employees?
The rule appears to extend to a specific type of public-sector compensatory time governed by 29 C.F.R. Section 553.22–.27, which is based on hours worked above the FLSA threshold. However, it likely does not apply to “other compensatory time” under Section 553.28, which is earned through non-FLSA standards—such as internal policies or collective agreements. As the article notes:
“We do not believe this law applies to 29 C.F.R. Section 553.28 ‘other compensatory time,’ which is time earned and accrued by an employee for employment in excess of a non-statutory (that is, non-FLSA) requirement and often considered ‘other’ compensatory time…”
This form of compensatory time is more common in public-sector workplaces, but until the Department of Labor issues additional guidance, employers should proceed with caution.
Timing and Income Limits
The new tax rule applies to tax years 2025 through 2028 and is retroactive to January 1, 2025—meaning overtime earned earlier in the year still qualifies. Employers are responsible for properly accounting for these wages.
However, the deduction is not unlimited. It is capped at $12,500 for single filers and $25,000 for joint filers, and phases out at higher income levels:
“The deduction is capped at $12,500 for single filers and $25,000 for joint filers. It is phased out by $100 for each $1,000 by which the taxpayer’s modified adjusted gross income exceeds $150,000 ($300,000 in the case of a joint return).”
Withholding Still Required
It’s important to note that withholding requirements remain unchanged. Overtime wages are still subject to:
“Federal income tax withholding, state and local tax withholding, as well as employment tax withholding, including Social Security and Medicare.”
Employees will later exclude qualified overtime compensation when filing their federal tax return, using an above-the-line deduction on their return.
Reporting and Compliance Expectations for Employers
As implementation begins, employers should focus on several critical compliance steps:
1. Prepare for Accurate Overtime Accounting
Most overtime is earned through policy or contract—not the FLSA. Since this law applies only to FLSA overtime, employers must distinguish and separately track qualifying hours.
2. Prepare for Accurate Compensatory Time Tracking
Public-sector employers must distinguish between FLSA-qualifying compensatory time and “other compensatory time.” As stated:
“Employers must be able to account for which form of compensatory time was earned by the employee.”
This distinction is crucial because usage rights and denial rules differ between the two types.
3. Update Form W-2 Reporting
Employers will need to report overtime wages separately on Form W-2, likely using Box 12 or 14. It is expected that:
“It is unlikely that reporting on Form W-2, Boxes 1, 3, and 5 would change.”
4. Continue Withholding as Usual
Employers must not mistake the deduction for a withholding exemption. As reiterated:
“The overtime provision does not create an exclusion from income subject to withholding.”
5. Avoid Risky Classification Changes
Employers may feel pressure to adjust compensation structures to benefit from the new deduction—but such changes can carry serious risks:
“Changing exempt employees to hourly, reducing their pay, and then allowing a tax deduction on ‘overtime’… may trigger a Department of Labor complaint resulting in an audit and may create liability depending on the facts of the situation.”
6. Communicate With Employees
Given likely employee interest—and pending IRS and DOL guidance—employers should consider creating a clear, proactive communication plan:
“Consider preparing an informative update for your employees.”
In summary, while the “No Tax on Overtime” rule could benefit many hourly workers, the compliance burden for employers—especially in the public sector—will be significant. Employers should begin preparing their systems, reviewing employee classifications, and watching closely for upcoming federal guidance. Our DC Employment attorneys will be here to aid every step of the way.