Leave encashment can provide a substantial financial benefit when an employee retires, resigns or leaves an organisation. For many salaried employees, it can form a significant part of their retirement payout. However, the tax treatment of leave encashment depends on whether it is received during service or at retirement, and whether the employee belongs to the government or private sector. Under Section 10(10AA) of the Income Tax Act, eligible employees can claim tax exemption on leave encashment, subject to specified conditions and limits.

Leave encashment refers to the amount paid by an employer in exchange for unutilised earned leave accumulated by an employee during service.

Many organisations allow employees to carry forward unused leave from one year to the next. Over time, this can result in a substantial leave balance, which can either be availed as leave or encashed as a monetary benefit when the employee exits the organisation.

The taxability of leave encashment depends on when the payment is received.

If an employee receives leave encashment while still in service, the entire amount is treated as salary income and is fully taxable according to the applicable income tax slab.

However, leave encashment received at the time of retirement, superannuation, resignation or other qualifying separation from service may qualify for tax exemption under Section 10(10AA).

Central and state government employees enjoy complete tax exemption on leave encashment received at the time of retirement.

Under Section 10(10AA)(i), the entire amount received towards encashment of unutilised earned leave is exempt from income tax. There is no upper monetary ceiling on the exemption available to government employees.

This makes leave encashment one of the most tax-efficient retirement benefits available to government staff.

The rules are different for employees of private companies, public sector undertakings and other non-government organisations. Under Section 10(10AA)(ii), the exempt amount is limited to the lowest of the following four amounts:

• Actual leave encashment received;
• Cash equivalent of unutilised earned leave, subject to a maximum accumulation of 30 days’ leave for each completed year of service;
• Average salary of the last 10 months immediately preceding retirement multiplied by 10;
• Rs 25 lakh.

The lowest of these four figures is treated as the exempt amount.

Any amount received above the eligible exemption is taxable under the head “Income from Salary”.

The Central Board of Direct Taxes (CBDT) increased the maximum leave encashment exemption limit for non-government employees from Rs 3 lakh to Rs 25 lakh with effect from April 1, 2023.

The revised limit provides significant tax relief for employees who have accumulated large leave balances during their careers.

However, the Rs 25 lakh exemption ceiling is a lifetime limit. If a taxpayer has claimed leave encashment exemption from a previous employer, the available exemption may reduce accordingly. Where leave encashment is received from more than one employer, the combined exemption claimed cannot exceed the prescribed lifetime limit.

For calculating leave encashment exemption, salary generally includes:

• Basic salary;
• Dearness allowance, to the extent it forms part of retirement benefits;
• Commission, where it is paid as a fixed percentage of turnover achieved by the employee.

Allowances, bonuses and most perquisites are generally excluded while calculating average salary for exemption purposes.

No. If leave encashment is paid after the death of an employee, the amount received by legal heirs is generally exempt from tax in the hands of the recipient.

This ensures that the benefit does not create an additional tax burden for family members receiving terminal dues.

Employees should carefully verify leave encashment details reported by their employer before filing their Income Tax Return (ITR).

In some cases, the entire leave encashment amount may be reflected in Form 16, while the eligible exemption may need to be claimed while filing the return.

Taxpayers should retain the following documents to support their claim:

• Service records;
• Leave balance statements;
• Salary details for the last 10 months before retirement;
• Leave encashment calculation provided by the employer.

Understanding the tax treatment of leave encashment can help employees make informed retirement and tax-planning decisions. While central and state government employees can claim full tax exemption on leave encashment received at retirement, private-sector employees are eligible for exemption only up to prescribed limits under Section 10(10AA) of the Income Tax Act. Reviewing leave balances, salary records and exemption calculations before filing an Income Tax Return (ITR) can help taxpayers maximise available tax relief and avoid errors while reporting retirement benefits.