What is leave encashment and how to calculate tax exemption?

Income Tax Income from Salary
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1

Many companies provide a fixed quota of paid leaves to their employees annually, and in case these leaves are not fully utilised, employees may have the option to convert them into monetary compensation. This policy is known as leave encashment.

Now the implementation of this policy varies from employer to employer. But in case your company has such a policy in place, and you’re planning to encash unused leaves, you will most likely have to pay tax on this additional income.

Let’s understand the details.

First of all, the amount received against unused leaves is added to your gross salary and mentioned in Form 16 as ‘Cash equivalent of leave salary encashment under section 10 (10AA).’

Now let us figure out when is the leave encashment amount taxable (or exempt).

The taxability of leave encashment depends on two things:

  1. First, whether you are a government employee or not, and
  2. Second, when did you receive this amount.

Read the below table.

leave encashment exemption
leave encashment exemption1323×287 29.3 KB

If you are a non-government employee and have received leave encashment upon retirement or resignation, the exempted amount is equal to the lowest of the following:

  1. Cash equivalent of unused leaves (in months) x last 10-month average salary
  2. The total amount of last 10 months salary
  3. Actual amount of leave encashment received from the company
  4. ₹25,00,000

Here the average monthly salary will include both basic component and dearness allowance.

Let’s take an example to understand this better.

Suppose you receive ₹9L as leave encashment at the time of retirement.

  • Actual leave encashment received: ₹9,00,000
  • Number of unused leaves: 120 days
  • No. of years served: 25 years
  • Last 10-month average salary (Basic + DA): ₹2,00,000

So the exempted amount will be the lowest of:

  1. 120 days ÷ 30 × ₹2,00,000 = ₹8,00,000
  2. 10 × ₹2,00,000 = ₹20,00,000
  3. Actual amount received = ₹9,00,000
  4. Maximum amount set by government = ₹25,00,000

The least amount is ₹8,00,000, so the maximum exemption will be ₹8,00,000.

Hence, the taxable component will be ₹9,00,000 - ₹8,00,000 = ₹1,00,000.

Now, let’s see how to report leave encashment amount in your ITR.

Leave encashment amount is reported under the head ‘Income from salary.’

As mentioned earlier, the total leave encashment amount will be added to your gross salary and you’ll have to claim the exempted amount as an allowance under Section 10(10AA).

The balance amount will be taxed at your applicable slab rates, just like other salary components.

If you have any queries on the taxability of leave encashment, you can comment your questions below.

2

Hi,
Hi, i have got a notice from income tax after filing the return based on this calculation. This is the notice or Seeking information/clarification requested:

Certain allowance claims made under Section 10 of the salary schedule were found to be inconsistent with the salary bifurcation that you have provided in the ITR. As a result, such allowances are being disallowed and added back to the gross salary.

This might be auto generated but i accepted this as in form 16 the leave encashment is not showing up. it is only there in payslip.

3

Hello @Susovan_Garai

Leave encashment exemption is available under Section 10(10AA), subject to the following conditions:

  • Government employees: Leave encashment received at the time of retirement is fully exempt.

  • Non-government employees: Exemption is available only on retirement or termination, limited to the least of:

    • Actual leave encashment received

    • ₹25,00,000 (lifetime limit)

    • 10 months’ average salary

    • Cash equivalent of leave (maximum 30 days per year of service)

  • Leave encashment during service is fully taxable.

  • Salary for exemption calculation includes Basic pay, DA (if forming part of retirement benefits), and eligible commission.

If these conditions are fulfilled, you may claim the exemption and reject the addition on the income-tax portal. Otherwise, the amount is taxable and the demand raised must be accepted and paid.

4

I actually left my previous company and joined a different company. will that be considered as during service or not?

5

If you left the previous company due to resignation, termination, or retirement and received leave encashment at that time, it will be considered for exemption under Section 10(10AA) (as applicable to non-government employees), subject to the limits.

6

Leave encashment is payment for unused leave; tax exemption depends on employment type, salary components, leave balance and government-prescribed limits.