How will the qualified overtime deduction interact with Social Security/Medicare tax calculations and state tax reporting?
Executive summary
The new “qualified overtime” deduction created by the 2025 law changes federal income tax treatment only — it reduces taxable income on the employee’s federal return when claimed, but it does not change payroll tax mechanics: Social Security and Medicare withholding remain unchanged and continue to be calculated on gross wages as before (including overtime) [1] [2] [3]. Employers will have new reporting lines (a proposed Box 12 code “TT” on Form W‑2 beginning for 2026 reporting) and must separately track the overtime premium so employees can claim the deduction when they file [1] [4].
1. How payroll taxes continue to apply: Social Security and Medicare unchanged
Social Security (OASDI) and Medicare (HI) payroll taxes are still levied on wages as they always have been: Social Security is 6.2% on earnings up to the yearly wage base ($184,500 for 2026) and Medicare is 1.45% on all wages with the additional 0.9% surtax applying above statutory thresholds — the qualified overtime deduction does not exempt those wages from FICA withholding or change the wage base rules [5] [6] [7] [8]. Multiple practitioner guides and employer advisories emphasize that overtime and tips remain subject to regular withholding for federal income tax, Social Security, and Medicare — the statutory change creates a later year-end federal income deduction, not a point-of-payroll exemption [2] [4] [9].
2. What employers must do now: tracking and W-2 reporting
Employers are being told to implement payroll changes to identify and separately track FLSA-qualified overtime premiums so those amounts can be reported on the redesigned W‑2 (draft instructions propose Box 12 code “TT” for 2026 reporting) and/or shown in Box 14 for 2025 to help employees compute their deduction for filing [1] [4] [10]. Until the 2026 W‑2 is finalized, guidance allows “reasonable methods” for estimating eligible overtime for the 2025 tax year, but the administrative burden on payroll systems and year‑end reconciliations will increase [11] [10].
3. Employee tax filing impact versus payroll tax reality
The tax benefit is realized when the employee claims the deduction on their Form 1040 for the applicable tax year; if the employee fails to claim the deduction they will have paid federal income tax on the overtime as normal — but regardless of whether the federal deduction is claimed, Social Security and Medicare taxes already withheld remain owed and are not refundable through this deduction [1] [4]. Practitioners caution that this is a timing and classification change for federal income tax only; payroll withholding during the year is intact and the deduction is a post‑withholding adjustment when the return is filed [9] [12].
4. State and local tax reporting: generally still taxable, but watch state conformity
Most employer guidance and tax commentary currently state that state and local income taxes will continue to apply to overtime and tips — states generally continue to withhold on gross wages and the new federal deduction does not automatically change state withholding obligations [2] [10] [3]. Whether a particular state allows a parallel deduction on the state return depends on state law and tax conformity decisions; available sources do not provide a comprehensive map of state responses, so employers and employees must monitor state tax agency guidance for conformity updates [2]. This reporting gap is significant for payroll teams because a federal W‑2 code will not by itself determine state tax treatment.
5. Practical risks, agendas and next steps for employers and workers
The policy presents a communication and systems risk: employees may assume “no tax on overtime” means no payroll taxes, creating confusion when Social Security/Medicare and state withholdings still occur — many payroll advisories and accounting firms explicitly stress that the law adds a deduction, not an exemption [4] [2] [9]. Employers face hidden administrative costs to segregate overtime premiums, update paystubs and W‑2 workflows, and reconcile quarterly returns; taxpayers face the risk of missing the deduction on their returns and thus overpaying federal income tax if records are poor [11] [10]. Until final IRS forms and state guidance land, conservative practice is to withhold and report payroll taxes as usual, track qualified overtime separately, and prepare for the new Box 12 reporting so employees can claim the deduction when filing [1] [4].