Leave Encashment Tax

Several companies allow their employees to carry forward their leaves accrued which can be encashed at the time of retirement of resignation. The amount received by using this facility is subject to the Leave Encashment Tax without any exemption.

As a salaried employee, you get many kinds of leave such as sick leave, casual leave, annual or earned leave, etc. Some of these days of leave can be carried forward to the following years. Many companies and all government organisations allow you to carry the leave days forward indefinitely. When such a facility exists, it is likely that at the time of resignation or retirement, you will be allowed to give the leave days back to the company and earn money instead. You will, therefore, be paid for all the leave that you did not take from the numbers you were entitled to. This is called leave encashment.

Tax on Leave Encashment

If you are turning in a large number of leave, then the salary you’ll earn for leave encashment might be quite high. This is especially true for government employees.

The following conditions apply when considering tax on leave encashment:

  • If you encash your leave while you are still working in the company/government office, then that amount is subject to tax without any exemption.
  • Government employees – whether they are with the Central Government or the State Government – are not liable to pay any tax on leave encashment income at the time of superannuation or resignation.
  • The income received by private sector employees as leave encashment after retirement or resignation is taxable as ‘Income from Salary’. But certain exemptions are applicable to this income. After allowing for the exemption, the remaining amount will be added to the regular income and taxed as per the income tax slabs.
  • Private sector employees can get exemption on leave encashment income under Section 10(10AA).

Exemption under Section 10(10AA)

A part of the leave encashment income at the time of superannuation or resignation is exempt from income tax payment. This exemption is applicable to the lowest of the below amounts:

  • Rs. 3 lakh
  • Actual leave encashment amount
  • Average salary (basic salary + dearness allowance) of the last 10 months before the employee’s retirement or resignation
  • Cash equivalent of pending leave days. The leave basis is a maximum of 30 days leave for every year of service.

Let us try to clarify this through an Example. Rajani Mathur resigned her job in a private company after 18 years of service. She had a leave allowance of 40 days per year, adding up to 720 days of leave during the whole of her service. Out of this, she had taken 500 days of leave, leaving her with 220 (7.3 months) to encash. She receives Rs. 2.64 lakh on encashment. Her basic salary plus DA was Rs. 36,000 per month for the last 1 year of her service. As for pending leave days for tax calculation, instead of 40, it would be considered that she received earned leave of 30 days per month. So the pending leave days would be 40 days (30 days x 18 years = 540 days — 500 leave days availed) instead of 220 days.

To know how much of this amount is exempted from taxation, let us calculate all 4 of the above numbers.

  • Rs. 3 lakh
  • Actual leave encashment amount: Rs. 2,64,000
  • Average salary of the last 10 months: Rs. 3,60,000
  • Cash equivalent of pending leave days: Rs. 48,000 (40 x per day average salary of Rs. 1,200)

The lowest of the above amounts is Rs. 48,000. Rajani Mathur will get exemption for that amount out of the Rs. 2.64 lakh that she received as leave encashment. The remaining amount – Rs. 2.16 lakh – will be subject to income tax as per her slab, i.e. between 10% to 30%.

Other Important Points:

If you encash your leave days more than once during your work history, the maximum exemption of Rs. 3 lakh is applicable to the total amount you earn as leave encashment income from all jobs. So if you have already claimed exemption on Rs. 1 lakh after resigning from one job, then in the next jobs you will have a maximum of Rs. 2 lakh available as exemption.

If your leave encashment is received by one of your legal heirs after your death, then that amount, however high, is not subject to taxation.

Each company has a different leave encashment policy. Some may allow you to continue your leave balance without any limit, while some put a cap on the number of years you can carry forward the remaining leave days for. If your company allows you to carry forward a large number of leave days, make sure you estimate the tax you’ll have to pay at the time of encashment. It might be beneficial not to wait too long to encash your leave in order to avoid getting a lump sum amount in hand. If the company has less than 30 days of leave per year, then the exempted amount will not be lower than the actual leave encashment amount, which will give you a higher exemption. 

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