No Tax on Overtime: OBBBA Impact on Municipal Payroll
OBBBA Update #2: What Illinois Governments Need to Know
Published: January 2025 | Updated: January 29, 2026
Policy Update Series: One Big Beautiful Bill Act (OBBBA)
As part of our ongoing commitment to keep our community informed of significant tax and compliance developments, we are providing updates on the recently enacted One Big Beautiful Bill Act (OBBBA). This legislation contains several provisions that directly affect municipal operations, payroll administration, and employee compensation.
We will continue to provide timely guidance as new IRS regulations, state responses, and implementation details are released.
Update #2: No Tax on Overtime
This update addresses the new "no tax on overtime" (overtime deduction) provision. We'll cover how it works, what remains unchanged, and immediate actions for municipal payroll, HR, and finance teams.
What the "No Tax on Overtime" Provision Does
Under Section 70202 of OBBBA:
- For tax years 2025 through 2028, taxpayers may claim an above-the-line deduction for qualified overtime compensation.
- The deduction is limited to $12,500 for single filers and $25,000 for joint filers.
- The deduction phases out for taxpayers with modified adjusted gross income (MAGI) above $150,000 (single) or $300,000 (joint).
- "Qualified overtime compensation" is defined as the amount of overtime pay in excess of the employee's regular rate (i.e., the "premium" portion required under FLSA) that is reported on a W-2, 1099, or other specified statement.
- The deduction is available to both itemizing and non-itemizing taxpayers.
- Employers and payors must file information returns with the IRS (or SSA) and furnish statements to employees showing the amount of qualified overtime compensation paid.
- For tax year 2025, employers may use a "reasonable method" to approximate qualified overtime on W-2s; stricter reporting is expected beginning in 2026.
How It Affects Municipal Employers & Employees
⚠️ IMPORTANT: This new deduction does not mean overtime pay is entirely tax-free. Municipalities must remain careful in payroll administration.
Key Points:
| Issue | What Changes / What Remains | Implication for Municipal Employers |
|---|---|---|
| Federal income tax on overtime premiums | The "premium" overtime portion (i.e., amount over regular rate) may be deducted by employees. | Employers still report all overtime wages; deduction is claimed by employee at tax time. |
| Withholding & Reporting | Overtime wages remain subject to regular withholding and reporting. Employers must separately identify qualified overtime amounts for informational purposes. | Payroll systems may need updates to segregate regular vs. overtime premium pay and report accordingly. |
| FICA / Social Security / Medicare | Overtime compensation remains subject to FICA taxes (employee & employer share). | No change in employer responsibility for payroll taxes. |
| Unemployment Taxes | Overtime pay continues to count in wage base for FUTA/SUTA. | No change in unemployment tax treatment. |
| Recordkeeping & Audit Risk | Employers must maintain detailed records to support the amounts reported as qualified overtime. | Strong recordkeeping is critical, especially in case of IRS audit. |
| Wage & Hour / FLSA Compliance | No alteration to existing wage and hour rules — overtime eligibility and pay must still comply with FLSA. | Ensure that overtime is calculated correctly and meets FLSA requirements. Comply with FLSA, which may be more restrictive as to what is classified as "hours worked" for calculation of overtime. |
| State & Local Taxation | The deduction only affects federal income tax. State and local jurisdictions may not conform to this deduction. | Municipal payroll teams must confirm whether state/local tax rules allow or disallow the deduction. |
Recommended Actions for Municipal Payroll / HR / Finance Teams
1. Engage with Payroll Provider / Software Vendor
- Request updates to enable separate tracking of overtime premium pay
- Ensure ability to produce the information statements required
- Examine how overtime is calculated (e.g., time-and-a-half) so that the "qualified overtime" portion can be isolated
2. Train Payroll & HR Staff
- Make sure staff understand the difference between "regular wages" vs. "qualified overtime premium"
- Train on how to capture that distinction in pay systems
3. Plan for 2025 Reporting
- For the first year, you may use a "reasonable method" to approximate qualified overtime amounts on W-2s
- Watch for IRS guidance for more precise reporting in 2026
4. Communicate with Affected Employees
- Let employees know how this new deduction may benefit them
- Emphasize that this is not a total tax exemption
- Clarify that federal, state, and payroll taxes may still apply
5. Monitor IRS & Treasury Guidance
- The rules remain subject to interpretation and administrative guidance
- Watch for definitions, reporting, and enforcement clarifications
6. Clarify "Hours Worked" Under FLSA
Under the Fair Labor Standards Act (FLSA), "hours worked" includes only the time an employee is actually on duty or permitted to work. It does not include time not worked, such as:
- Holidays
- Vacation
- Sick leave
- Other paid time off
These do not qualify toward overtime calculations or deductions.
Official Government Sources & Verification
The information in this article is based on official federal law and IRS guidance. For your reference, here are the authoritative government sources:
📋 Federal Law
One Big Beautiful Bill Act (Public Law 119-21)
- H.R. 1 on Congress.gov - Official bill text and legislative history
- Full Bill Text (Engrossed) - U.S. Government Publishing Office
- Signed into law: July 4, 2025
- No Tax on Overtime provisions: Section 70202
🏛️ IRS & Department of Labor Resources
IRS OBBBA Provisions Page
- One, Big, Beautiful Bill Provisions - Comprehensive IRS guidance hub
- Section 70202 overview and implementation guidance
- Employer reporting requirements
- Tax year applicability (2025-2028)
Department of Labor - Fair Labor Standards Act
- Fair Labor Standards Act Overview - Official FLSA guidance
- Defines "hours worked" for overtime purposes
- Establishes 40-hour workweek standard
- Clarifies which work time counts as "hours worked"
IRS Form W-2 Instructions
- Form W-2 Information - Official IRS form guidance
- Employer reporting requirements for excluded overtime
- New Box 14 reporting for 2026 tax year
📅 Key Dates Confirmed by Federal Law
| Date | Event | Source |
|---|---|---|
| July 4, 2025 | OBBBA signed into law | Public Law 119-21 |
| Tax years 2025-2028 | Section 70202 applies | OBBBA Section 70202 |
| 2026 tax year | First year with W-2 reporting | IRS guidance |
| After 2028 | Provision expires (unless extended) | OBBBA Section 70202 |
⚠️ Important: "Hours Worked" Definition
According to the Department of Labor's Fair Labor Standards Act (FLSA):
- "Hours worked" includes all time the employee is required to be on duty or at a prescribed workplace
- Includes: Actual work time, required meetings, mandatory training, on-call time (if restricted), short breaks (under 20 minutes)
- Excludes: Meal periods (30+ minutes, completely free from duties), commute time (generally), off-duty time between shifts
- Overtime threshold: Hours worked beyond 40 in a workweek (not per day)
Source: 29 CFR Part 785 (Hours Worked regulations)
⚠️ Income Limits Apply
According to OBBBA Section 70202:
- Single filers: $12,500 maximum annual exclusion
- Joint filers: $25,000 maximum annual exclusion
- Calculation: Based on total overtime earnings, not overtime hours
- What happens after limit: Additional overtime is fully taxable
Example: If you earn $15,000 in overtime pay but file single, only $12,500 is excluded from federal income tax. The remaining $2,500 is taxable.
In Summary
The OBBBA overtime deduction provides a tax benefit for employees who work overtime, but it does not eliminate payroll taxes or change employer reporting obligations. Municipal payroll teams must:
- ✅ Update payroll systems to track qualified overtime separately
- ✅ Maintain detailed FLSA-compliant records
- ✅ Communicate clearly with employees about what this means
- ✅ Monitor IRS guidance as it develops
- ✅ Coordinate with payroll vendors for W-2 reporting
Need Help with OBBBA Compliance?
John Kasperek Co., Inc. provides this information as a resource for Illinois municipalities navigating federal tax law changes affecting payroll operations.
Contact Us Read More Articles📰 Stay Connected, Stay Informed
These tax law updates are just the beginning and guidance will continue to evolve at both the state and federal level. Follow John Kasperek Co., Inc. on LinkedIn to stay ahead of the curve with timely updates, insights, and resources tailored for Illinois governments, schools, and municipalities.
Subscribe to The Public Ledger newsletter for monthly updates on tax law changes and compliance requirements.
About John Kasperek Co., Inc.
Founded in 1989, John Kasperek Co., Inc. is a trusted CPA firm specializing in governmental accounting for Illinois municipalities, school districts, townships, and nonprofits in the Chicagoland and Northwest Indiana region.