Is Overtime Taxed at a Different Rate?

Many believe overtime pay is taxed at a higher rate than regular wages, but this perception does not align with federal income tax principles. There is no separate tax rate applied specifically to overtime earnings. Overtime pay is part of an individual’s total income, and all earned income is subject to the same tax rules. This article clarifies how income is taxed and explains why overtime might appear to be taxed differently from a paycheck perspective.

Understanding Income Tax Basics

The United States employs a progressive income tax system, meaning that as an individual’s taxable income increases, the percentage of that income paid in taxes generally increases. This system is structured with various tax brackets, where different portions of income are taxed at escalating rates.

It is helpful to distinguish between marginal and effective tax rates. A marginal tax rate is the rate applied to the last dollar earned, which corresponds to the highest tax bracket an individual’s income reaches. In contrast, the effective tax rate is the average rate of tax paid on all taxable income, calculated by dividing total tax liability by total taxable income. The progressive nature of the tax system means that only the income falling within a specific bracket is taxed at that bracket’s rate, not the entire income.

How Overtime Withholding Works

Employers are required to withhold federal income taxes from employee paychecks throughout the year as an estimate of annual tax liability. Overtime pay, along with bonuses and commissions, is generally categorized as “supplemental wages.” The methods employers use to calculate withholding on these supplemental wages can create the impression that overtime is taxed at a higher rate.

Two primary methods are used for withholding on supplemental wages. The first is the “aggregate method,” where the employer combines the supplemental wages with the employee’s regular wages for the current or most recent payroll period. Income tax withholding is then calculated as if this total amount were a single regular wage payment for that period. This approach can push the total income for that specific pay period into a higher withholding bracket, resulting in a larger amount of tax being withheld from that particular paycheck.

The second method is the “flat rate method,” often used when supplemental wages are identified separately from regular wages. For federal income tax, a flat rate of 22% is typically applied to supplemental wages up to $1 million in a calendar year. If supplemental wages exceed $1 million in a calendar year, the amount above this threshold is subject to a mandatory flat rate of 37%.

Your Final Tax Liability

When individuals file their annual tax return, all income earned throughout the year is combined to determine total gross income. This total income is then subjected to the progressive tax bracket system. The purpose of filing a tax return is to reconcile the amount of tax actually owed for the year with the total amount of tax that was withheld from paychecks.

If the amount withheld during the year exceeds the actual tax liability, the taxpayer will receive a refund. Conversely, if too little was withheld, the taxpayer will owe additional taxes. The increased earnings from overtime can increase an individual’s total taxable income, potentially moving a portion of their income into a higher tax bracket, which then applies only to that specific portion of income. Overtime income is integrated into an individual’s total taxable income and is subject to the same federal income tax rates as all other ordinary income.