Leave encashment can form a sizeable part of a retirement payout.
However, the tax treatment depends on whether the employee worked for the government or in the private sector, and how much leave has accumulated over the years.
Leave encashment during service remains fully taxable
Employees should note that tax relief is available only when leave encashment is received at the time of retirement, superannuation, resignation or other qualifying separation from service as permitted under the law.
Any leave encashment received while an employee is still in service is treated as salary income and is fully taxable, according to the applicable income tax slab.
Full tax exemption for government employees
For central and state government employees, leave encashment received on retirement is fully exempt from income tax under Section 10(10AA)(i).
There is no upper monetary ceiling on the exemption. The entire amount received towards encashment of unutilised earned leave at retirement is exempt from tax.
This makes leave encashment one of the key tax-efficient retirement benefits available to government employees.
How tax exemption works for private sector employees
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 restricted to the lowest of the following four amounts:
• Actual leave encashment received at retirement;
• Cash equivalent of unutilised earned leave, subject to a maximum accumulation of 30 days’ leave for every completed year of service;
• Average salary of the last 10 months immediately preceding retirement, multiplied by 10;
• Rs 25 lakh.
The exemption available is, therefore, not automatically equal to the leave encashment amount received. Employees must compare all four calculations and claim the lowest figure as the exempt amount.
Any amount exceeding the eligible exemption becomes taxable under the head “Income from Salary.”
Rs 25 lakh exemption limit
A significant relief for private sector employees came through a Central Board of Direct Taxes (CBDT) notification issued in 2023.
The notification increased the maximum exemption limit for non-government employees from Rs 3 lakh to Rs 25 lakh with effect from April 1, 2023.
This higher limit applies to eligible leave encashment received on retirement and can substantially reduce the tax burden for senior employees who have accumulated large leave balances over long careers.
However, the Rs 25 lakh cap is a lifetime limit. If a taxpayer has claimed leave encashment exemption from a previous employer, the available limit may be reduced accordingly.
What is considered ‘salary’ for calculation?
For the purpose of computing the exemption, salary includes:
• Basic salary;
• Dearness allowance, to the extent it forms part of retirement benefits;
• Commission, if it is paid as a fixed percentage of turnover achieved by the employee.
Other allowances and perquisites are generally not included while calculating the average salary for exemption purposes.
Special relief for legal heirs
In cases where leave encashment is paid after the death of an employee, the amount received by legal heirs is generally exempt from tax.
This ensures that the benefit does not become a tax burden for family members receiving terminal dues.
How to claim the exemption while filing ITR
Taxpayers should carefully verify the leave encashment details reported by their employer.
In many cases, the full amount may appear in Form 16, while the employee needs to separately claim the eligible exemption while filing the income tax return.
To support the claim, taxpayers should retain documents such as:
• Service records;
• Leave balance statements;
• Salary details for the last 10 months before retirement;
• Leave encashment calculation provided by the employer.
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