Summary of this article
Leave encashment is tax-free for government employees at retirement. For private-sector employees, it’s exempt up to Rs 25 lakh under Section 10(10AA) if received at retirement or resignation, while any encashment during service is fully taxable. Only basic salary and DA are considered for exemption calculation.
Leave encashment refers to receiving monetary compensation in lieu of unutilised paid leaves. Many organisations allow employees to encash part of their leave either annually or at the time of retirement or resignation. From a tax perspective, the treatment of leave encashment varies depending on when it is received and whether the employee works in the government or the private sector.
For Government Employees
For Central and state government employees, the rule is simple. It is tax-free under income tax.
Says Preeti Sharma, partner, global employer services, tax & regulatory services, BDO India: “Leave encashment received at the time of retirement or resignation is fully exempt from income tax. No limits or calculations are required, and the entire amount is tax-free under Section 10(10AA)(i) of the Income-Tax Act, 1961.”
For Private Sector Employees
For private sector employees, the rules differ.
a) If encashed during employment period
If leaves are encashed while still employed, the amount is fully taxable. The exemption under Section 10(10AA) applies only when you receive such payment at the time of retirement, resignation, or otherwise cease employment.
b) If encashed at the end of employment (Retirement / Resignation)
Exemption is provided under Section 10(10AA)(ii) of Income-Tax Act, 1961. Under this section, exemption from tax is available for least of the following amounts:
Actual amount received as leave encashment; or
Rs 25 lakh (this new higher limit applies for retirements or resignations on or after April 1, 2023, as per CBDT Notification No. 31/2023); or
Average salary of the last 10 months before retirement/resignation; or
Cash equivalent of earned leave (maximum of 30 days per completed year of service).
For the purposes of the above calculation, salary means only the basic salary and dearness allowance.
TDS and Proofs
Employers are required to deduct tax at source (TDS) on the taxable portion of leave encashment. “Employees should verify this in Form 16 and Form 26AS while filing their returns,” says Sharma.
Key Takeaways
Leave encashment is fully exempt for government employees at retirement.
For private-sector employees, the total exemption is capped at Rs 25 lakh (overall limit post-April 2023).
For the purpose of calculating the exemption, only basic salary and DA is to be considered. If your employer is calculating leave encashment on gross salary, a part of such encashment is likely to be taxable even if the payout is below Rs 25 lakh.
Any encashment during service is fully taxable.
Keep proper salary slips, leave records, and employer certificates as proof in case of scrutiny. If in doubt, contact a tax professional.
"If you have received multiple leave encashments from different employers, the aggregate amount of the exemptions claimed at different points of time cannot exceed Rs 25 lakh. If you have claimed leave encashment exemption in the past, it is important to report the same to the current employer. This will help in deduction of the correct amount of TDS. Otherwise, you will end up paying self- assessment tax with interest while filing your tax return,” says Sharma.
