Is Overtime Taxed More? Why Withholding Makes It Seem So

Many people believe overtime pay is taxed at a higher rate than regular wages, leading to a perception of disproportionate deductions. This misconception stems from how federal income tax withholding is applied. Overtime earnings are not subject to a higher actual tax rate than any other income; all income is ultimately taxed at the same progressive rates based on total annual earnings. The appearance of higher taxation arises from specific withholding methods employers use for supplemental wages.

How All Income Is Taxed

The United States operates under a progressive income tax system, meaning higher income levels are subject to higher marginal tax rates. This system divides taxable income into brackets, with each portion of income within a particular bracket taxed at a specific rate. For instance, the first portion of income is taxed at the lowest rate, the next portion at a slightly higher rate, and so on.

It is important to distinguish between a marginal tax rate and an effective (or average) tax rate. A marginal tax rate is the rate applied to the last dollar earned, while the effective tax rate is the total tax paid divided by total taxable income. Overtime pay simply adds to an individual’s total income, and like all other earnings, it is taxed according to the marginal rate of the bracket into which it falls.

Why Overtime Withholding Can Seem Higher

The primary reason overtime pay might appear to be taxed more heavily is due to how employers calculate and withhold taxes from these earnings, which are considered “supplemental wages” by the Internal Revenue Service (IRS). Supplemental wages include various forms of pay beyond regular wages, such as bonuses, commissions, and overtime. Employers are required to estimate an employee’s tax liability and withhold funds throughout the year to cover this estimate.

One common method employers use for withholding on supplemental wages is the percentage method. When supplemental wages, like overtime, are identified separately from regular wages, employers can withhold federal income tax at a flat rate. For amounts up to $1 million in a calendar year, this flat rate is currently 22%. This flat percentage might be higher than an employee’s typical effective tax rate on their regular wages, leading to a larger amount withheld from an overtime paycheck and the perception of a higher tax.

Alternatively, employers may use the aggregate method, especially when supplemental wages are paid together with regular wages and not separately identified. Under this method, the employer combines the overtime pay with the regular wages for that pay period and calculates withholding as if the combined amount were a single, regular paycheck. This can push the total income for that specific pay period into a higher withholding bracket, resulting in a significantly larger amount withheld for that check. These withholding rules are designed to ensure sufficient taxes are collected throughout the year, rather than reflecting the actual tax rate applied to the income.

Determining Your Annual Tax

All forms of income, including regular wages, overtime pay, and bonuses, are aggregated at the end of the tax year to determine an individual’s total taxable income. The actual tax liability for the year is then calculated based on this total taxable income and the applicable progressive tax brackets.

The total amount of federal income tax withheld by an employer throughout the year, from both regular and overtime earnings, is then compared to this calculated annual tax liability. Employers report total wages paid and taxes withheld on Form W-2, Wage and Tax Statement, which is provided to employees annually. Taxpayers use this information, along with other relevant financial details, to complete Form 1040, the U.S. Individual Income Tax Return. If the total amount withheld exceeds the actual tax liability, the taxpayer will receive a refund. Conversely, if too little was withheld, the taxpayer will owe additional tax.