Leave encashment refers to the amount of monetary benefit received by an employee in exchange for the unused leaves an organisation provides in a year.
As per Indian labour laws, every salaried employee is entitled to a particular number of paid leaves from an organisation. The quantity of paid leaves varies from company to company. Many organisations offer a facility to carry forward the paid leaves in case they are not utilised in a single year. Employees can avail of the paid leave balance when they leave the organisation, retire, or continue the service.
What Kind of Leaves Are Eligible for Encashment?
Not all types of leaves are considered for leave encashment, and different types of organisations deal with leave encashment differently. For a government employee, various government policies are applicable. Under Section 10(AA), there is an exemption for the leave encashment. The treatment could vary depending on when employees encash their leaves (retirement or resignation).
Earned or privileged leaves are those earned in the previous year and enjoyed in the preceding year. This leave can be carried forward for up to three years as per shops and establishment acts but may vary from company to company. In most organisations, this type of leave qualifies for leave encashment. On the other hand, medical leaves, maternity leaves (in the case of female employees), and casual leaves are not considered for leave encashment calculation.
Is Leave Encashment Taxable?
Leaves available for encashment during employment or at the time of retirement/resignation are fully taxable. The amount received for leave encashment forms a part of the income from salary. However, employees can claim the leave encashment exemption under Section 89 of the Income Tax Act.
Under What Conditions Can Leave Encashments Be Exempted From Tax?
When the leave encashment option is used at the time of retirement or resignation, you can avail of partial or complete exemptions. The conditions for exemption are:
- Leave encashment is fully exempted when any legal heir receives the encashment amount on behalf of a deceased employee.
- For government employees, leave encashment is exempt based on the computation provided under Section 10 (10AA) ii, which includes the balance of taxable income from salary, if any.
How to Calculate Leave Encashment?
Let's understand the leave encashment calculation step-by-step with an example.
Mr. Sharma is a government bank employee working as a Scale I officer. On his retirement from the bank, his leave balance (eligible for encashment) is 250 leaves.
1. Leave Details
Balance Earned Leaves (EL): 250
Maximum leaves allowed for encashment: 300
Leave encashed during service: Nil
EL authorised for encashment: 250
2. Last Salary Details
Last basic pay (BP): INR 80,000
Dearness Allowance @38.92% (DA rate as on January 2023): INR 31,136
Total payments/Basic Salary (BP and DA): INR 1,11,136
3. Calculation of Earned Leaves (PL) Encashment
PL or earned leaves authorised for encashment: 250
Total emoluments (BP and DA): ₹ 1,11,136
EL encashment: (Basic salary / 30) x number of earned leaves
= (1,11,136 / 30) x 250
= INR 9,26,133
How to Calculate Tax on Leave Encashment?
If you have accumulated many leaves, the monetary benefit you will earn for leave encashment might be quite high. It will then come under the tax purview.
The following tax implications apply when considering a tax on leave encashment:
- If you encash your leave while still in service (private or government organisation), that amount is subject to tax without any exemption.
- Government employees - whether employed with the Central Government or the State Government - do not have to pay any tax on leave encashment income during superannuation or resignation.
- Non-government employees can avail of exemption on leave encashment amount under Section 10 (10AA). However, only a few exemptions apply 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.
Exemption Under Section 10 (10AA)
A certain amount of the leave encashment income at the time of superannuation or resignation is exempt from a tax obligation. This exemption applies to the lowest among the following amounts:
- INR 3,00,000
- Actual leave encashment amount
- Average salary (Basic Pay + Dearness Allowance) of the last 10 months before the employee's retirement or resignation
- Cash equivalent of pending leave days, i.e., salary per day x unutilised leave (the leave basis here is a maximum of 30 days for every completed year of service).
For instance, Mr. Sharma resigned from company ABC. His monthly salary is INR 1 lakh. He was entitled to 30 days of paid leave every year. His leave balance at the time of resignation from the company is 30. His leave encashment of INR 1 lakh (INR 1,00,000/30 x 30 days of unused leaves). Hence, the exempt leave encashment will be the lowest of the following:
- Amount notified by the Government- INR 3 lakhs
- Actual leave encashment amount – INR 1 lakh
- Average salary for the last 10 months - INR 10 lakhs (INR 1 lakh x 10 months)
- Salary per day x unutilised leave balance (considering maximum 30 days leave for every year of service completed) – INR 1 lakh / 30 days = INR 3,333 one day salary x 30 days = INR 99,990
Hence, total leave encashment of INR 99,990 lakh would be exempt.
Now, Mr. Sharma joins company Jupiter Money and serves there for 10 years before his resignation. His salary is INR 2.4 lakh per month. Mr. Sharma was entitled to 30 days of leave per year. He utilised 250 leaves during the entire service, and his leave balance at the time of resignation was 50 leaves. His leave encashment is calculated as INR 4 lakhs (4,00,000/30 x 50).
The leave encashment exemption will be the lowest among the following:
- Amount notified by the Government - INR 2,00,010 (INR 3 lakhs less INR 99,990 claimed exempt earlier)
- Actual leave encashment amount – INR 4 lakhs
- Average salary for the last 10 months – INR 24 lakhs (INR 2.4 lakhs x 10 months)
- Salary per day x unused leave (considering a maximum of 30 days leave per year for every year of service completed) – INR 2.4 lakhs / 30 days = INR 8,000 per day x 50 days = INR 4 lakhs
Under the circumstances, the leave encashment exempt amount would be INR 2,00,010, and the rest would be taxable.
In cases where the employer credits more than 30 days per year, computation of Leave Encashment will be done by restricting the leave balance to a maximum of 30 days per year leave.
For instance, Ms. Mathur served in a company for 10 years. The company credits 35 days per year as leave. Ms. Mathur utilised a total of 60 days in her service period. Her monthly salary is 1 lakh. The leave encashment received is INR 9.6 lakhs.
Leave credits - 30 days
No years of service - 10 years
Total leave credit - 300 days
Leaves utilised - 60 days
Unutilised leave balance - 240 days
The exempt leave encashment will be the least of the following:
- Amount notified by the Government- INR 3 lakhs
- Actual leave encashment amount – INR 9.6 lakh
- Average salary for the last 10 months – INR 10 lakhs (INR 1,00,000 x 10 months)
- Salary per day x unutilised leave (considering a maximum of 30 days per year) for every year of completed service – INR 1,00,000 / 30 days = INR 3,333 per day x 240 days = INR 8 lakhs.
Hence, the amount of leave encashment exempt would be INR 3 lakhs, and the rest of INR 6.6 lakhs would be taxable leave encashment.
Wrapping Up
Every organisation has a different leave encashment policy. Some may allow you to carry forward your leave balance without any limit, while some limit the number of years you can carry forward the remaining leave days for. If your company permits you to carry forward many leaves, you must ensure you estimate the tax you'll be liable to pay at the time of encashment.
At times, it is beneficial not to wait too long to encash your leave to avoid getting a lump sum amount in hand. If the company has a leave policy that does not allow more than 30 days of leave per year, the exempt amount will not be lower than the actual leave encashment amount. This will give you a higher exemption.
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FAQs
1. Is leave encashment taxable on resignation?
Leave encashment is taxable on resignation for an employee working in a private company. Tax is computed as per section 10 (10AA). However, in the case of a government employee, leave encashment received after retirement or resignation is tax exempted.
2. Is leave salary and leave encashment the same thing?
No, they are not the same thing. Leave salary, accumulated over time and encashed later, sums up to leave encashment. Therefore, leave salary is a part of leave encashment.
3. How I claim tax benefits for leave encashment?
In case of leave encashment, some tax benefits can be claimed under Section 89 of the Income Tax Act.
