Yes, overtime is taxed in Arizona. It is wages, so it counts as income and payroll withholds Arizona income tax from it like any other pay. What changed is that for 2025 through 2028, workers can deduct the premium part of federally required overtime on their federal return, and Arizona now lets them subtract the same amount on their state return. Payroll keeps withholding as usual; the benefit arrives when the employee files.
This article replaces our August 2025 post on the new overtime rules. Since then the IRS has issued detailed guidance and Arizona has passed its own law, so the answer below reflects both.
What does the federal overtime deduction cover?
The One Big Beautiful Bill Act created a deduction for qualified overtime compensation for 2025 through 2028. It is available whether a worker itemizes or takes the standard deduction. IRS summary of the new deductions
Qualified overtime is only the premium part of overtime that the Fair Labor Standards Act requires. When an employee is paid time and a half, the extra half is the qualified amount; the regular rate for those hours is not. IRS questions and answers on the overtime deduction
The deduction is capped at $12,500 a year, or $25,000 on a joint return, and it shrinks once modified adjusted gross income passes $150,000, or $300,000 for joint filers. A married worker has to file jointly to claim it, and needs a Social Security number valid for employment. IRS questions and answers on the overtime deduction
Here is how the premium works. An employee earning $20 an hour works 100 overtime hours in a year at time and a half, which is $30 an hour, for $3,000 of overtime pay. Of that, $2,000 is the regular rate and $1,000 is the premium. The $1,000 is qualified overtime compensation; all $3,000 is still wages. IRS explanation of the premium portion
Workers figure the deduction on the new Schedule 1-A filed with Form 1040. IRS: what to know about the overtime deduction
Is overtime taxed in Arizona?
Arizona taxes individual income at a flat 2.5 percent, and overtime is part of wages. Employers withhold Arizona income tax as a percentage of gross taxable wages, at the rate each employee chooses on Form A-4. Arizona Department of Revenue withholding calculations
In June 2026 the Legislature passed and the Governor signed a tax bill, HB 4168 and SB 1861 (Laws 2026, chapter 140). It adds an Arizona subtraction for the qualified overtime a taxpayer deducts on the federal return, to the extent it is not already excluded from Arizona gross income, and it applies back to January 1, 2025. Arizona Legislature fact sheet, as enacted
For 2025 returns, the Department of Revenue said the subtraction is claimed on Form 140, not Form 140A or 140EZ. Part-year residents and nonresidents subtract only the overtime included in their Arizona gross income. Arizona Department of Revenue worksheet
So for an Arizona worker, overtime is taxed when it is paid, and the qualified premium comes back off taxable income at filing time on both the federal and the Arizona return.
What changes for employers?
Payroll itself does not change. Overtime is still subject to federal income tax withholding and to both the employer and employee shares of Social Security and Medicare tax. IRS General Instructions for Forms W-2 and W-3
Reporting does change. For 2025, employers did not have to report qualified overtime separately on Form W-2, and employees could figure the amount using the methods in IRS Notice 2025-69. For 2026 and later years, employers must report it. IRS questions and answers on the overtime deduction
On the 2026 Form W-2 it goes in box 12 with code TT. Report the total qualified overtime you paid, even when it is more than the employee can deduct. IRS General Instructions for Forms W-2 and W-3
Employees who want smaller refunds and bigger paychecks can account for the deduction in step 4(b) of the 2026 Form W-4. IRS Form W-4
| Payroll task | What to check | Why it matters |
|---|---|---|
| Classify | Is each employee nonexempt under the FLSA? | Only FLSA-required overtime qualifies |
| Separate | Is the premium tracked apart from straight-time pay? | The premium is the reported amount |
| Report | Is box 12 code TT set up for 2026 Forms W-2? | Separate reporting is required from 2026 |
| Withhold | Are income, Social Security and Medicare withholding unchanged? | The deduction is claimed at filing |
| Explain | Do employees know about Form W-4 step 4(b)? | They can adjust withholding for the deduction |
Only overtime the Fair Labor Standards Act requires counts. If an employee is not eligible for FLSA overtime, extra pay under a union contract or company policy is not qualified overtime. IRS questions and answers on the overtime deduction
If your payroll system cannot separate the premium, fix that before year end. The payroll services page describes the payroll work the office handles.
What about tips and the other 2025 changes?
The same federal law created a separate deduction for qualified tips, and Arizona's 2026 bill added a matching subtraction for it. Arizona Legislature fact sheet, as enacted
The law also changed several business provisions, including bonus depreciation. Those deserve their own review against your numbers; the tax planning page covers that work.
Contact the office if you want a second look at how overtime is tracked and reported in your payroll.
Frequently asked questions
Is overtime pay taxed in Arizona?
Yes. Overtime is wages, so it counts as income and Arizona income tax is withheld from it. For the years the federal overtime deduction applies, Arizona also lets you subtract the qualified overtime you deduct on your federal return.
Does the overtime deduction lower Social Security and Medicare taxes?
No. It is an income tax deduction claimed on the return. Overtime pay is still subject to income tax withholding and to Social Security and Medicare taxes.
Does overtime paid under a union contract or company policy count?
Only overtime the Fair Labor Standards Act requires counts, and only the premium part above the regular rate. Overtime paid only because of a contract or policy does not qualify.
Sources
- IRS: tax deductions for working Americans and seniors
- IRS: questions and answers about the deduction for qualified overtime compensation
- IRS: what to know about the No Tax on Overtime deduction
- IRS: General Instructions for Forms W-2 and W-3
- IRS: Form W-4
- Arizona Legislature: HB 4168 and SB 1861 fact sheet, as enacted
- Arizona Department of Revenue: Middle Class Tax Cuts Package worksheet
- Arizona Department of Revenue: withholding calculations
About the author
Craig L. Elggren, CPA, PC is a Gilbert accounting practice. This article explains federal and Arizona rules as of September 2026 in general terms; how they apply depends on each worker's pay and filing situation.