No Tax on Overtime Rules Contractors Must Get Right

Episode 180 of the Construction Accounting Podcast with George Ghazarian, CPA · 5 min 27 sec · Published 5 August 2026

Your crew heard that overtime is tax-free now. They are already spending the refund. Their checks are going to look exactly the same, and they are going to ask you why.

Here is what the deduction actually covers, what the caps and phase-outs do to it, why California takes a chunk back, and what has to change in your payroll coding before you file.

It Is a Deduction, Not a Tax-Free Paycheck

There is a provision people are calling “no tax on overtime.” It runs for tax years 2025 through 2028. On the surface it sounds like a gift: your crew works overtime, overtime is not taxed, everybody is happy. That name is doing a lot of lying.

Overtime does not become tax-free on the paycheck. Your guys still get federal tax withheld on overtime every single pay period. What this actually is is a deduction they claim when they file their return, and it only applies to a slice of the overtime, not all of it. If you do not understand that difference, you will have a shop full of employees expecting a windfall that never shows up.

Only the Premium Portion Qualifies

Time-and-a-half has two parts: the regular rate, and the extra “half” on top. Only that half — the premium — counts for the deduction. If a guy makes $20 an hour and you pay him $30 for overtime, only the extra $10 is qualified overtime. Not the whole $30. That single point is where most of the crew-floor confusion starts, and it is the first thing to correct when somebody asks you about their check.

It Has to Be FLSA Overtime, Which Ambushes California

The deduction applies to FLSA overtime. That is federal overtime — over 40 hours in a work week. California has daily overtime: over 8 hours in a day, you owe overtime under state law. That daily overtime does not qualify for the federal deduction. Only the federal, over-forty-in-a-week kind does.

For a California contractor that is not a technicality. A big chunk of the overtime your crew earns was never eligible in the first place, which means the gap between what your guys expect and what they get is wider here than almost anywhere else.

The Caps and the Income Phase-Outs

Even qualifying overtime is limited. The deduction maxes out at $12,500 for a single filer and $25,000 married filing jointly. It phases out once income climbs past $150,000 single and $300,000 joint. The deduction is claimed on the employee’s return, so the cap and the phase-out get applied to their filing situation, not to your payroll. Two guys on the same crew with the same overtime hours will not necessarily land in the same place.

Your W-2 Reporting Changed

This is the part that lands on you, the owner. Qualified overtime now has to be captured and reported separately. Your 2026 W-2s look different than anything you have filed before. If your payroll system is not tracking qualified overtime as its own line — if it is just lumped in with gross wages — your W-2s will not be right. Mess that up, and once transition relief ends, you are looking at penalties. Your crew will hold you responsible for how this shows up on their return, and the IRS will hold you responsible for how you report it. That is a lot of exposure sitting on your payroll.

California Did Not Conform

California did not conform to this deduction. Every dollar of overtime premium is still fully taxed by the state, at rates that run all the way up past 13 percent. So even the guys who do get the federal break still owe California on that same overtime. If your crew thinks overtime is completely tax-free, they are wrong twice: once on the federal cap, once on California not playing along.

Put real numbers in front of them. A single worker with $15,000 of qualifying federal overtime does not deduct all of it — the deduction stops at the $12,500 cap. At a 22 percent marginal rate that is roughly $2,750 back. California still taxes that same overtime, costing him around $1,400 to the state. That is the real picture. Not tax-free — a modest federal break, partially clawed back by California.

What to Fix Before Filing Season

Get straight on what qualifies: premium portion only, federal over-forty-a-week overtime only, not California daily overtime. Make sure your payroll system tracks qualified overtime as its own line so the W-2s come out right. Then set expectations with your crew before they see the number and decide you shorted them.

A composite of how this plays out: an electrical contractor with a solid crew and a lot of overtime on a big commercial job had morale building around a refund that was never coming in the size his guys imagined, and his payroll was not tracking the premium separately at all, so his W-2s were going to be wrong. Fixing the payroll coding and handing the crew a one-page explainer solved both halves of the problem: no IRS issue, no blindsided employees, no owner holding the bag.

The short version

• The overtime provision runs for tax years 2025 through 2028 as a filing-time deduction
• Only the premium half of time-and-a-half qualifies, not the full overtime rate
• Federal FLSA overtime over 40 hours a week qualifies; California daily overtime does not
• The deduction caps at $12,500 single and $25,000 joint, phasing out past $150,000 and $300,000
• Qualified overtime must be reported separately, so 2026 W-2s differ from prior filings
• California did not conform, so the state still fully taxes every overtime premium dollar

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This episode is general information about how these rules work, not advice for your situation. Tax law changes and the right answer depends on your entity, your income and your circumstances. Talk to a CPA before acting on it.