The One, Big, Beautiful Bill Act (OBBBA), enacted on July 3, 2025, created a new federal tax deduction on overtime pay that applies retroactively to the 2025 tax year. This, of course, applies to cities as employers. On Nov. 21, the IRS issued new guidance (PDF) to help employers and employees prepare for the upcoming filing season. The 2025 tax portal is expected to open in late January.
Because not all states have adopted similar rules, employers should encourage workers to confirm whether “no tax on overtime” applies to their state returns as well.
When Do These New Rules Apply?
The tax deduction is available for tax years 2025 through 2028. For 2025, the IRS is offering penalty relief (PDF): employers will not be penalized if they don’t give workers correct information returns or statements that lay out how much they made in overtime.
This relief was deemed necessary because the IRS won’t be updating information returns like the W-2 or 1099 for 2025 to reflect the new deductions. Employers were not previously required to separately identify overtime compensation, and many municipalities will need time to update their payroll systems.
How the Overtime Deduction Works
The OBBBA allows eligible taxpayers to deduct up to $12,500 for single filers or $25,000 for joint filers in overtime with phaseouts beginning at an income of $150,000 ($300,000 for joint filers). To qualify, a taxpayer must have a Social Security number and, if married, must be filing jointly.
The deduction applies to “qualified overtime compensation,” defined as the overtime pay required under section 7 of the Fair Labor Standards Act (FLSA) that exceeds an employee’s regular rate of pay. However, some workers are exempt from FLSA overtime rules. For example, certain law enforcement or fire protection employees in agencies with fewer than five covered employees. The FLSA also permits certain public safety employees to calculate overtime on work periods longer than a standard 40-hour week.
How to Determine Qualified Overtime Compensation
Because employers are not required to separately report qualified overtime compensation for 2025, this amount may not be shown on a W-2 except possibly in Box 14 or on an attached statement. Consequently, individuals who are not provided with this information must make a reasonable effort to determine whether they are considered FLSA-eligible employees. For all years that the deduction is in place, an individual may deduct an amount equal to the qualified overtime compensation received during the taxable year.
If no separate amount is provided, the IRS allows FLSA-eligible employees to:
- Treat the separate accounting requirement as met as long as overtime pay is properly reported on the individual’s Form W-2, Form 1099-NEC or Form 1099-MISC; and
- Use other documentation, such as earnings or pay statements, invoices or similar statements that support the determination, to calculate qualified overtime compensation using a “reasonable method.”
Examples of How to Determine Overtime Pay
- Example 1: Individual 1 works in law enforcement and is paid $15,000 of total annual overtime pay on a “work period” basis of 14 days that complies with section 207(k) of the FLSA. For purposes of determining the amount of qualified overtime compensation received in tax year 2025, Individual 1 may include $5,000 ($15,000 divided by 3).
- Example 2: Individual 2 works for a local government agency that gives compensatory time at a rate of one and one-half hours for each overtime hour worked under 29 USC 207(o). In 2025, Individual 2 was paid wages of $4,500 with respect to compensatory time off taken in accordance with section 207(o). For purposes of determining the amount of qualified overtime compensation received in tax year 2025, Individual 2 may include $1,500, one-third of these wages for purposes of determining qualified overtime compensation under section 225(c).
How Cities Should Prepare
As an employer, cities may want to make their employees know about this change to the 2025 overtime pay calculations by providing basic information and a fact sheet with examples of how to calculate overtime pay. Additionally, cities should begin to discuss internally how they will implement this tracking for the tax season starting on Jan. 1. Consulting with your Human Relations department on these changes is important.
Connect with NLC
The IRS is still drafting and releasing details related to the “no tax on overtime” deduction. NLC will continue to share updates as additional guidance becomes available. For questions, please send us an email.
About the Author
FEMA’s Announces New Counter-UAS Grant Program to Empower Cities, Towns and Villages
- Yucel Ors
Cities 102: Understanding the Role, Impact and Operations of Local Government
Three Things to Know Video Series: November 2025
From the Event: City Fiscal Conditions 2025
City Fiscal Conditions 2025
