How do state daily‑overtime rules interact with the federal qualified overtime deduction for 2025?
Executive summary
The federal “no tax on overtime” deduction for tax year 2025 allows employees to deduct the FLSA-required overtime premium—the one‑half portion of time‑and‑one‑half pay—subject to caps and income phaseouts, and it applies only to overtime that federal law requires (not to state- or contract‑mandated overtime) [1] [2] [3]. Because many states (notably California) impose daily or other overtime rules that exceed the FLSA, employers and employees must separate FLSA‑qualified overtime from state‑required premiums to determine federal deduction eligibility and to meet evolving federal reporting expectations [4] [5].
1. The federal deduction’s narrow scope: only the FLSA “premium” counts
The new federal deduction created by the One Big Beautiful Bill Act covers the additional premium required by the Fair Labor Standards Act—generally the “half” in time‑and‑one‑half pay for hours over 40 in a workweek—and excludes any extra pay an employer provides beyond that federal requirement (for example, double‑time on holidays, collective bargaining premiums, or state‑mandated overtime that exceeds FLSA) [2] [6] [7]. Treasury and IRS guidance for 2025 reiterates that qualified overtime is limited to the extra pay over the regular rate that FLSA compels, and that an individual who is not FLSA‑eligible generally cannot claim qualified overtime [1] [7].
2. State daily overtime creates a two‑track reality for payroll
Where state laws require daily overtime (or overtime at thresholds below 40 hours per week), the amounts paid under those state rules often include premiums that are not “qualified” for the federal deduction, which forces payroll systems to segregate FLSA‑qualified premiums from state‑only premiums for correct federal reporting and employee tax claims [4] [5]. Sources advising employers emphasize that businesses operating in states with local overtime regimes must track FLSA overtime separately, report only the federally‑qualified premium for the federal deduction, and maintain distinct records for different overtime types [4] [6].
3. 2025 is a transition year: reasonable methods and temporary reporting relief
Because the federal change was enacted mid‑year and agencies needed time to update forms and systems, the IRS allowed “reasonable methods” for employers to approximate qualified overtime for tax year 2025 and provided penalty relief for incomplete reporting; full, specific W‑2 reporting was slated to begin with later guidance and draft forms indicated a new code for qualified overtime (e.g., draft Box 12 code “TT”) [8] [7] [9]. Employers therefore may rely on approximations for 2025 but are warned that relief is transitional and that stricter reporting will apply in subsequent years [6] [10].
4. Employee impact: possible deduction, but payroll taxes and state taxes still apply
Eligible employees may reduce federal taxable income by deducting their qualified overtime—subject to annual limits (e.g., caps and income phaseouts described in guidance)—but overtime earnings remain subject to Social Security, Medicare, and potentially state income and payroll taxes where applicable, and the deduction is temporary for 2025–2028 unless Congress extends it [3] [11] [12]. Practically, workers in states with daily overtime may find only part of what they earned qualifies federally, and they may need to reconstruct the qualified amount themselves for 2025 if employers do not provide separate reporting [10] [11].
5. What employers and payroll teams must do now
Payroll operations in states with extra overtime rules must update systems to segregate FLSA overtime premiums from state‑mandated premiums, adopt reasonable methods for 2025 calculations, and prepare for mandatory W‑2 reporting in later years; failure to do so won’t necessarily trigger immediate penalties for 2025 given IRS transition relief, but it will complicate employee claims and future compliance assessments [6] [13] [4]. Guidance from legal and municipal advisories stresses a cost/benefit analysis for public and private employers and anticipates additional Treasury/IRS clarifications that will shape exact reporting mechanics [13] [10].
6. Limits of current reporting and open questions
The sources clearly establish federal limits on the deduction and the exclusion of state‑only or CBA‑required overtime, and they describe transition relief and the need for separate tracking, but they do not comprehensively address whether or how individual state tax codes will conform to the federal deduction in 2025—so any conclusion about state income‑tax treatment must await state revenue rulings or legislative action [11] [4]. Until states publicly state conformity positions, employers and employees in daily‑overtime jurisdictions must plan conservatively: segregate pay streams, document methods used for 2025, and be ready to adjust once final federal and state reporting rules are issued [10] [7].