One of the new provisions that has generated considerable buzz is the deduction for qualified overtime compensation. Understanding the facts, as well as the nuances, of this new benefit is key to effectively advising your clients.
Understanding the New Overtime Compensation Deduction:
The OB3 Act establishes new IRC §225, which permits individuals to claim a deduction for their qualified overtime compensation[1].
- Deduction Limits: The deduction is capped at $12,500 for individuals or $25,000 for those filing a joint return.
- Impact on Taxable Income: Despite much of the information floating around the internet, this deduction does not reduce Adjusted Gross Income (AGI). Instead, it directly reduces taxable income and is explicitly not an itemized deduction. Section 70202 of OB3 amends IRC §63 to include the Overtime Deduction (a deduction to compute taxable income), as opposed to §62 (a reduction for AGI).
- Effective Dates: This provision applies to tax years beginning after December 31, 2024. However, it terminates for tax years beginning after December 31, 2028.
Defining “Qualified Overtime Compensation”:
The term “qualified overtime compensation” has a specific meaning under the OB3 Act. It refers to amounts paid to an individual that are required under §7 of the Fair Labor Standards Act (FLSA).
The deduction is limited to the overtime premium[2], which is the difference between the taxpayer’s regular hourly pay rate and the overtime rate.
- Exclusions: It’s important to remember that §224 qualified tips are expressly excluded from what constitutes qualified overtime compensation.
- Reporting Requirements: For employees to claim this deduction, the total amount of qualified overtime compensation must be reported separately on Form W-2. For overtime compensation pertaining to tax years prior to 2026, the Secretary of the Treasury may allow approximation by any reasonable method.
Modified Adjusted Gross Income (MAGI) Limitations:
The deduction is subject to a phase-out based on the taxpayer’s modified adjusted gross income. The allowed deduction (after applying the $12,500 or $25,000 limits) is reduced by $100 for each $1,000 that the taxpayer’s MAGI exceeds $150,000 ($300,000 on a joint return).
Important Taxpayer Requirements:
Several requirements must be met for a taxpayer to claim this deduction successfully:
- Social Security Number (SSN): The taxpayer must include their Social Security number (SSN) on their tax return. This SSN must be valid for employment and issued before the due date of the tax return (including extensions).
- Joint Filing for Married Individuals: Generally, if the taxpayer is married, they must file a joint tax return to claim this deduction.
- Exceptions to “Married” Status: An individual may not be considered married for this deduction, even if legally married, provided all the following conditions are met:
- They file a separate return and maintain a household for more than half of the tax year, which serves as the principal place of abode for a child they can claim as a dependent.
- They furnish over one-half of the cost of maintaining the household during the tax year.
- Their spouse is not a household member during the last six months of the tax year.
The following example demonstrates the proper application of the deduction, especially as it relates to the amount of overtime that is eligible:
- Saul is an overtime-eligible employee earning $18 per hour.
- He is single and has a MAGI of $53,500.
- During tax year 2025, Saul worked 27 overtime hours at $27 per hour, resulting in $729 in overtime pay.
- Since Saul’s MAGI ($53,500) is well below the $150,000 threshold, no phase-out applies to his deduction.
- His deduction is calculated as 27 overtime hours multiplied by the $9 per hour differential (the difference between his $27 overtime rate and his $18 regular rate).
- Therefore, Saul’s qualified overtime deduction is $243.
The OB3 Act’s overtime compensation deduction introduces a valuable tax benefit for many eligible individuals. A thorough understanding of its definitions, MAGI limitations, and filing requirements will be essential for accurately advising your clients and ensuring they can properly claim this deduction in the coming tax years.
For an in-depth look at all of the OB3 provisions, check out our 2-hour on-demand webinar for tax changes applying to 2025 and register for the Update for 2025 Returns for a full-day analysis.
[1] OB3 §70202
[2] FS-2025-03