Summary (tl;dr)

A new federal income tax deduction for overtime pay, part of the "One Big Beautiful Bill Act," became law in July 2025, taking effect for the 2025 tax year. However, several U.S. states and Washington D.C. are opting out of this federal tax break at the state level, meaning residents in those areas will still pay state income tax on their overtime earnings.

Essential Background

The concept of exempting overtime and tips from taxation gained significant political traction during the 2024 U.S. presidential campaign, with both former President Donald Trump and Vice President Kamala Harris proposing similar measures to support workers. Historically, overtime earnings have been subject to federal, state, and local income taxes, as well as payroll taxes like Social Security and Medicare, treated similarly to regular wages. President Trump specifically advocated for eliminating taxes on overtime pay to incentivize work and benefit diligent Americans.

The Full Story

President Donald Trump signed the "One Big Beautiful Bill Act" (OBBBA) into law on July 4, 2025, which includes a new federal income tax deduction for qualified overtime compensation. This deduction, which is not a full exemption, allows individuals to deduct up to $12,500 of eligible overtime pay (or $25,000 for joint filers) from their federal taxable income. It specifically applies to the "premium" portion of overtime earnings, such as the extra half-pay in a time-and-a-half scenario, for non-exempt workers under the Fair Labor Standards Act (FLSA). The deduction is effective for tax years 2025 through 2028 and phases out for higher-income earners, starting at a Modified Adjusted Gross Income (MAGI) of $150,000 for single filers.

Despite the federal deduction, several U.S. states and Washington D.C. have moved to "decouple" their state tax codes from this federal change, aiming to prevent significant state revenue shortfalls. This means that while federal income tax might be reduced for qualifying overtime, residents in these states will still pay state income tax on those earnings. States that have reportedly taken steps to reject or bypass the federal deduction include Washington (via an emergency amendment in Washington D.C.), New York, Illinois, Colorado, and Maine. The Internal Revenue Service (IRS) announced in November 2025 that employers will receive penalty relief for the 2025 tax year regarding the reporting requirements for these new overtime and tip tax provisions, acknowledging the mid-year enactment of the Act.

Why It Matters

The "no tax on overtime" policy is intended to encourage more work and offer financial relief to middle-income individuals who work beyond standard hours. However, the policy has sparked discussions regarding its fairness, potential impact on labor markets, and whether the tax code should favor specific employment structures. Critics argue that the deduction primarily benefits a specific segment of middle-income workers and could create discrepancies between salaried and hourly employees. The decisions by various states to decouple from the federal deduction underscore the financial pressures states face, as adopting the federal change would lead to substantial losses in state revenue. This divergence between federal and state tax treatment creates added complexity for both taxpayers and employers, particularly since state and local taxes, as well as Social Security and Medicare taxes, still apply to overtime wages.

Geographic Location

• United States (federal "One Big Beautiful Bill Act" signed into law)
• Washington, D.C., District of Columbia, United States (City Council passed an emergency amendment rejecting the federal overtime tax deduction)
• New York, United States (introduced provisions to bypass the federal overtime tax law)
• Illinois, United States (has not adopted federal exemptions and plans to require add-backs for state taxes)
• Colorado, United States (rejected the federal overtime tax deduction and requires taxpayers to add back federally exempt overtime income for state taxes)
• Maine, United States (rejected the federal overtime tax deduction)
• Kentucky, United States (introduced legislation for similar state-level tax exemptions on overtime)
• Maryland, United States (introduced legislation for similar state-level tax exemptions on overtime)
• Nebraska, United States (introduced legislation for similar state-level tax exemptions on overtime)
• New Jersey, United States (introduced legislation for similar state-level tax exemptions on overtime)