Excluding overtime pay from the individual income tax, and including applicability provisions

Description

House File 1024 excludes overtime pay from the individual income tax.

The Bill applies to tax years beginning on or after January 1, 2026.

Background

Compensation classified as overtime is not to be earned at less than one and one-half times the regular rate at which a person is employed, according to 29 U.S.C. §207. Iowa automatically conforms to the Internal Revenue Code (IRC) if there are federal changes, as codified in 2018 Iowa Acts, chapter 1161 (Income and Sales Tax Modification Act). At the time of this analysis, the federal government has not exempted overtime pay from the individual income tax.

Assumptions

• Administrative costs to the Iowa Department of Revenue (IDR) would be minimal.
• An average effective Iowa income tax rate of 3.8% is applied to tax years beginning January 1, 2026 (TY 2026).
• Withholding changes under the Bill will begin on January 1, 2026, which is halfway through FY 2026.
• The Bill would apply primarily to workers in the manufacturing, construction, health care, and public safety industries who are eligible for overtime.
• According to the IDR, Iowa workers in manufacturing, construction, and health care work an average of 3 hours of overtime per week in a tax year, while public safety employees work an average of 40 minutes of overtime per week in a tax year.
• According to the IDR, there is a seasonally adjusted average of 227,000 manufacturing workers, 86,000 construction workers, 59,000 health care workers, and 5,000 public safety workers in Iowa.
• According to the IDR, the statewide average hourly overtime wage rate is $38.22 for a worker in the manufacturing sector, $48.90 for a worker in the construction sector, $41.73 for a worker in the health care sector, and $42.09 for a public safety worker.
• Inflation is applied at approximately 2.3% annually on Iowa wages through calendar year 2031 and is based on Moody’s projections.
• The taxable income of the average worker will exceed the value of the standard deduction under both current law and the proposal.
• There is no change in eligibility of tax credit claims that may affect income tax revenue to the State.
• Since tax year (TY) 2026 will be the first year the exclusion is available, the first fiscal impacts to the General Fund will take place beginning in FY 2026.
• According to the IDR, approximately 51.8% of tax year impacts will occur in the first fiscal year and 48.2% of tax year impacts will occur in the second fiscal year.
• The first decrease in local option income surtax will take place beginning in TY 2026 for FY 2027.
• The income surtax for schools is a local option tax that is based on a taxpayer’s Iowa income tax liability. Law changes that lower Iowa income tax liability also lower the amount of income surtax owed by any taxpayer subject to the surtax. For this projection, the surtax is assumed to equal 2.5% of State individual income tax liability.

Fiscal Impact

The exemption in HF 1024 will decrease revenue to the General Fund by the following amounts:

• FY 2026 = $48.4 million
• FY 2027 = $94.4 million
• FY 2028 = $96.6 million
• FY 2029 = $98.8 million
• FY 2030 = $101.1 million
• FY 2031 = $103.4 million

The decrease in tax liability is also projected to decrease the statewide local option income surtax for schools by the following amounts:

• FY 2026 = $0
• FY 2027 = $2.3 million
• FY 2028 = $2.4 million
• FY 2029 = $2.4 million
• FY 2030 = $2.5 million
• FY 2031 = $2.6 million

Sources

• Iowa Department of Revenue
• National Institutes of Health
• Bureau of Labor Statistics
• Legislative Services Agency analysis