“No Tax on Overtime” in California: What Small Employers Actually Need to Track

Sep 23

If you have even one hourly employee, someone has probably asked you about “no tax on overtime.” Here’s the short version, plus the part California makes trickier.

What changed

The 2025 federal tax law created two new deductions that workers claim on their own federal return:

Overtime: up to $12,500 a year, or $25,000 for married couples filing jointly.
Tips: up to $25,000 a year.
Both start phasing out above $150,000 of income ($300,000 joint), and both are set to run for 2025 through 2028 only.

The IRS’s draft 2026 Form 1040, posted in September, gives these deductions their own line, pulling from a new Schedule 1-A. It’s still a draft, but it shows where this is going: this is a permanent fixture of the return for the next few years, not a one-time thing.

The first catch: only the “half” counts

The deduction covers the premium part of overtime, not the whole overtime paycheck. Say someone earns $20 an hour and works 10 overtime hours at $30. The deductible part is the extra $10 an hour, so $100, not $300.

The California catch, twice over

One: only overtime required by federal law counts. Federal overtime is based on hours over 40 in a workweek. California also requires daily overtime and double-time, and overtime that’s owed only under state law doesn’t qualify for the federal deduction.

Two: California doesn’t follow either deduction on the state return. Your employee may get a federal break and still pay California tax on the full amount.

What this means for you as the employer

Your payroll has to tell the two kinds of overtime apart. If every overtime hour lands in one bucket, you can’t report the qualifying amount correctly.
2026 W-2s report it. Starting with the W-2s you’ll file in early 2027, qualified overtime goes in Box 12 with code TT.
Run tips through payroll. Tips handed out off the books can’t be documented, and your staff lose the deduction.
Don’t promise anyone a number. What an employee saves depends on their income and filing status, not on you.

What I’d do before December

Pull one payroll report and ask a simple question: can it show federal overtime premium separately from California-only overtime? If yes, you’re set. If not, fix it now, in a quiet month, instead of in January when the W-2s are due.

If you run payroll yourself and aren’t sure how your setup handles this, bring me one pay stub and fifteen minutes. Book Your Appointment Here.

Ning Bouasana

I'm Ning, founder of 1 Stop Solutions, Inc., a Clovis-based accounting practice for founders and business owners who'd rather build their business than wrestle with spreadsheets. With a bachelor's in Business Management & Accounting and over a decade working alongside CPAs — from small businesses to corporate taxes for large companies — I bring that full range of experience to every client. My approach is simple: clean books, honest advice, and outside-the-box strategy that helps you maximize what you keep while staying fully compliant. No jargon, no judgment — just clear numbers and a plan you can actually follow.

https://www.1stopsolutionsinc.com