Do More Taxes Come Out of Overtime?

Many individuals often observe that a larger portion of their overtime earnings seems to be withheld for taxes, leading to a common belief that overtime pay is taxed at a higher rate. This perception is not entirely accurate, as overtime income is not taxed at a different rate than regular pay; all income is subject to the same tax rules. The difference often lies in how taxes are withheld from these additional earnings. This article will explain why more taxes might appear to be withheld from overtime and how to understand your overall tax obligations.

How All Income is Taxed

The United States operates under a progressive income tax system. As an individual’s taxable income increases, higher portions of that income may be subject to higher tax rates. This system uses tax brackets, each assigned a specific marginal tax rate. A marginal tax rate is the rate applied to the last dollar earned, not the entire income. For example, if you are in the 22% tax bracket, only income within that bracket is taxed at 22%, while income in lower brackets is taxed at their respective lower rates.

At the end of the tax year, all sources of an individual’s taxable income are added together to determine their total gross income. This includes regular wages, overtime pay, bonuses, and commissions. This aggregated gross income is then used to calculate the overall tax liability based on the progressive tax brackets. The more income an individual earns, the more likely some of that income will fall into a higher marginal tax bracket.

Overtime pay simply contributes to total annual income, potentially causing a portion of earnings to be taxed at a higher marginal rate. Overtime itself is not singled out for a unique, higher tax rate; rather, it can push total income into a higher bracket. This annual calculation of actual tax owed differs from the amount withheld from each paycheck, which is a prepayment of taxes.

Understanding Overtime Withholding

While overtime pay is not taxed at a higher rate, it often appears that way due to how employers withhold taxes. Tax withholding is the amount an employer deducts from each paycheck as a prepayment towards an individual’s annual tax liability. The Internal Revenue Service (IRS) classifies overtime pay as “supplemental wages,” similar to bonuses or commissions. This classification triggers specific rules for how taxes are withheld from these payments.

Employers use one of two methods for withholding federal income tax from supplemental wages. The first is the percentage method, also known as the flat rate method. For supplemental wages up to $1 million in a calendar year, employers often withhold federal income tax at a flat rate of 22%. This 22% is a withholding rate applied regardless of the employee’s regular tax bracket, and it is not the actual tax rate that will apply to that income at year-end.

The second method is the aggregate method. Under this approach, the employer combines supplemental wages with the employee’s regular wages for the current or most recent pay period. Taxes are then calculated on this combined amount as if it were the employee’s regular pay for that period. This method can result in higher withholding because it temporarily annualizes a higher income, potentially placing a larger portion of that paycheck’s earnings into higher tax brackets for withholding.

In both scenarios, whether the flat 22% rate or the aggregate method is used, the amount taken out of an overtime paycheck might seem disproportionately large. This is because withholding is an estimate of future tax liability, not the final tax calculation. Any over-withholding due to these methods is reconciled when an individual files their annual tax return, often resulting in a tax refund if more was withheld than owed.

Managing Your Tax Withholding

Individuals can manage their tax withholding to align it more closely with their actual tax liability, particularly if they frequently earn overtime. The W-4 Form, officially known as the Employee’s Withholding Certificate, is the primary document used to inform an employer how much federal income tax to withhold from paychecks. Adjusting this form can help prevent significant over-withholding or under-withholding throughout the year.

While “allowances” were removed from the W-4 Form starting in 2020, employees can still modify their withholding by indicating additional income, deductions, or credits. Individuals can choose to have an additional dollar amount withheld from each paycheck. This is useful for those who consistently experience higher withholding from overtime and prefer to reduce a potential large refund at year-end in favor of more take-home pay throughout the year.

The IRS offers an online tool, the Tax Withholding Estimator, available on IRS.gov. This estimator helps individuals calculate their appropriate withholding based on their financial situation, including fluctuating income from overtime. Utilizing this tool can help individuals avoid a large tax bill at year-end, which might incur penalties. It also helps prevent a substantial refund, which essentially means providing the government with an interest-free loan. Review W-4 settings annually or whenever significant life events occur, such as marriage, the birth of a child, or starting a second job, to ensure withholding remains accurate.