Leave Encashment: Tax Benefits on Retirement

Leave encashment is a common benefit provided to employees for unused leave days accumulated during their service. The Income Tax Act, 1961, provides specific exemptions for leave encashment, especially at the time of retirement, to reduce the tax burden on employees.

This blog explores the concept of leave encashment, its taxation under different scenarios, exemptions available under Section 10(10AA), and examples to clarify its implications.

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What is Leave Encashment?

Leave encashment refers to the payment made by an employer to an employee for unused leave days. It can occur:

1. During Service: Encashment of leave while still employed.
2. At the Time of Retirement or Resignation: Encashment of leave accumulated until the date of retirement or resignation.

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Taxability of Leave Encashment

The tax treatment of leave encashment depends on the type of employment and when the encashment occurs:

1. Leave Encashment During Service

• Fully taxable as Income from Salaries.
• Included in the gross salary and taxed according to applicable slab rates.

2. Leave Encashment at Retirement or Resignation

Taxability depends on the category of the employee:

1. Government Employees:
   • Fully exempt under Section 10(10AA)(i) if received upon retirement.
   • Applicable to both Central and State government employees.
2. Non-Government Employees:
   • Exempt under Section 10(10AA)(ii), subject to specific limits.

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Exemption Limits for Non-Government Employees

For non-government employees, the exemption for leave encashment at the time of retirement is the least of the following:

1. ₹3,00,000: Maximum limit specified under Section 10(10AA)(ii).
2. Actual Leave Encashment Received: The total amount paid by the employer.
3. 10 Months’ Salary: Based on the average salary drawn in the 10 months immediately preceding retirement or resignation.
4. Cash Equivalent of Leave: Calculated for leave days accumulated up to a maximum of 30 days per year of completed service.

Note: Salary for this purpose includes basic salary and dearness allowance (if applicable).

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How to Calculate Leave Encashment Exemption?

Formula for Cash Equivalent of Leave:

(Average Monthly Salary × Number of Leave Days Accumulated) ÷ 30

Example 1: Government Employee

Mr. Sharma, a State Government employee, retires and receives ₹5,00,000 as leave encashment for 240 days of unused leave.

• Exemption: Fully exempt under Section 10(10AA)(i).
• Taxable Amount: ₹0

Example 2: Non-Government Employee

Ms. Priya, a private sector employee, resigns after 20 years of service. Her details are:

• Last Drawn Salary (Basic + DA): ₹50,000 per month
• Leave Encashment Received: ₹6,00,000
• Accumulated Leave: 240 days

Step-by-Step Calculation:

1. Cash Equivalent of Leave:
   (₹50,000 × 240 ÷ 30) = ₹4,00,000
2. 10 Months’ Average Salary:
   ₹50,000 × 10 = ₹5,00,000
3. Exemption: Least of the following:
   • ₹3,00,000 (Maximum Limit)
   • ₹6,00,000 (Leave Encashment Received)
   • ₹4,00,000 (Cash Equivalent of Leave)
   • ₹5,00,000 (10 Months’ Salary)

Exemption Allowed: ₹3,00,000
Taxable Amount: ₹6,00,000 – ₹3,00,000 = ₹3,00,000

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Important Points to Remember

1. Exemption Limit is Lifetime: The ₹3,00,000 exemption for non-government employees is a one-time limit for all leave encashment received during their lifetime.
2. Leave Taken During Service: Leave taken or encashed during service is fully taxable.
3. Maintenance of Records: Employers must maintain proper leave records for accurate computation of exemptions.

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Tax Planning for Leave Encashment

1. Plan Leave Usage: Use leave systematically during your service to avoid a large taxable amount at retirement.
2. Verify Form 16: Ensure the leave encashment amount and exemptions are correctly reflected in your Form 16.
3. Consider Timing: Plan the timing of your retirement or resignation to optimize tax savings.

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Frequently Asked Questions (FAQs)

1. Is leave encashment during service taxable?

Yes, leave encashment during service is fully taxable as income from salaries.

2. Are government employees fully exempt from tax on leave encashment?

Yes, government employees are fully exempt under Section 10(10AA)(i) for leave encashment received at retirement.

3. Can non-government employees claim full exemption on leave encashment?

No, non-government employees can claim exemptions only up to the limits specified under Section 10(10AA)(ii).

4. Is the ₹3,00,000 exemption limit applicable for multiple retirements?

No, the ₹3,00,000 exemption is a lifetime limit across all employers.

5. How does leave encashment affect pensioners?

Leave encashment received post-retirement is taxable for non-government employees unless exempt under Section 10(10AA).

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Conclusion

Understanding the tax implications of leave encashment under Section 10(10AA) helps employees plan their finances better. While government employees enjoy full exemptions, non-government employees can minimize their tax liability by leveraging the exemption limits and maintaining proper records. Tax planning and timely decisions can ensure maximum benefits.