Why Your Overtime Gets Taxed More and What to Do

Many people believe their overtime wages are taxed at a higher rate than regular pay. This common perception often leads to frustration when a larger portion of an overtime paycheck seems to disappear due to deductions. The reality is that overtime earnings are subject to the same tax rates as other income. The difference lies in how employers handle these additional earnings for tax withholding, rather than a separate, higher tax rate being applied. This article clarifies why your overtime pay might appear to be taxed more and explains the underlying mechanisms.

The Progressive Tax System

The United States operates under a progressive income tax system. As an individual’s taxable income increases, higher portions of that income are subject to progressively higher tax rates. Income is divided into segments, known as tax brackets, with each bracket having its own marginal tax rate. For instance, the first portion of income might be taxed at a lower rate, while income exceeding a certain threshold falls into a higher bracket and is taxed at a higher marginal rate.

Only income within a specific bracket is taxed at that bracket’s marginal rate. Income earned below that threshold is still taxed at the lower rates applicable to previous brackets. Even if additional income, such as overtime, pushes total earnings into a higher tax bracket, only the amount entering that new bracket is subject to the higher marginal rate. The effective tax rate (total tax paid divided by total taxable income) will remain lower than the highest marginal rate due to this progressive structure.

How Income Tax Withholding is Calculated

Employers are responsible for withholding income tax from an employee’s wages throughout the year, based on information on their Form W-4, Employee’s Withholding Certificate. This form helps the employer estimate the employee’s annual tax liability and determine the correct amount of tax to deduct from each paycheck. For regular wages, employers annualize the pay to estimate total yearly earnings. They then use Internal Revenue Service (IRS) tax tables and W-4 information to calculate the appropriate withholding amount for that pay period.

For supplemental wages, such as overtime pay, bonuses, commissions, or severance pay, employers have specific withholding methods. One common approach is the “percentage method,” applied when supplemental wages are separately identified from regular wages. Under this method, if total supplemental wages paid to an employee during the calendar year are less than $1,000,000, the employer may withhold a flat 22% of those wages. For supplemental wages exceeding $1,000,000 in a calendar year, a higher flat rate applies to the excess.

Another method for supplemental wages is the “aggregate method.” This occurs when supplemental wages are combined with regular wages, treated as a single payment for withholding. The employer calculates withholding as if the combined amount were a regular paycheck, which can result in higher calculated withholding for that specific pay period. This happens because the annualized income for that single pay period appears much higher, potentially pushing more income into higher estimated withholding brackets, even if it’s a temporary spike. This increased deduction is merely a withholding estimate and not the final tax rate applied to the overtime income.

Withholding Versus Actual Tax Liability

The amount of income tax withheld from each paycheck is an estimate designed to ensure an individual pays enough tax throughout the year to cover their annual tax obligations. This withholding is not the final tax an individual owes; rather, it is a prepayment towards their total tax liability. Actual tax liability is determined after the end of the tax year when an individual files their annual income tax return, typically using Form 1040, U.S. Individual Income Tax Return.

During the tax filing process, all income sources, including regular wages and supplemental pay like overtime, are totaled. Tax deductions and credits are then applied to this total income to calculate the true amount of tax owed for the entire year. If the total tax withheld from paychecks exceeds the actual tax liability, the individual will receive a tax refund. Conversely, if too little tax was withheld, the individual will owe additional tax when filing their return. While overtime may lead to a larger amount being withheld from a specific paycheck, this is an over-withholding, resulting in a larger refund or smaller amount due when the tax return is filed.

Managing Your Tax Withholding

Understanding the difference between withholding and actual tax liability allows individuals to manage their tax situation more effectively, especially if they frequently earn overtime or have other fluctuating income. The primary tool for adjusting tax withholding is the Form W-4, Employee’s Withholding Certificate. By making changes to this form, such as adjusting the number of allowances claimed or indicating additional amounts to be withheld, employees can influence the amount of tax deducted from each paycheck.

Individuals can use resources like the IRS Tax Withholding Estimator tool, available on the IRS website, to determine the optimal withholding amount. This tool allows users to input their income, deductions, and credits to receive a personalized recommendation for their W-4. The goal of adjusting withholding is to align the amount withheld more closely with the actual tax liability, thereby avoiding either a substantial refund (meaning too much tax was withheld throughout the year) or a large tax bill at year-end.