PROSPERR.IO

Leave encashment confuses people endlessly. You accumulate leave over years. Company policy might let you encash some during employment. Or you get a lump sum when you retire or quit. Question is: how much actually gets taxed?

The answer depends entirely on when you encash. During working years? Different rules. At retirement or resignation? Different rules again. Government employees have separate treatment from private sector. And the calculation methods aren't exactly intuitive.

Getting this wrong means either paying unnecessary tax or discovering during scrutiny that you claimed an exemption you weren't entitled to.

Let's break down exactly how leave encashment taxation works, what exemptions exist, and how to calculate actual tax liability.

What Leave Encashment Actually Means

Leave encashment is payment for unutilized leave. Most contracts give earned leave, casual leave, sick leave. You accumulate leave each month and carry forward what you don't use.

Some companies let you encash a portion while employed. Others allow encashment only when you leave.

Payment calculation: (Number of leave days) × (Daily salary rate)

Daily salary varies by company. Some use basic salary divided by 30. Others use the average salary of the last 10 months divided by 30. Check your company's leave policy.

Two Completely Different Tax Treatments

Tax treatment splits into two:

Leave encashment during service: Fully taxable as salary. No exemptions. Every rupee gets added to income and taxed at slab rates.

Leave encashment at retirement/resignation: Partially exempt under Section 10(10AA). Has limits and calculation methods, but some portion escapes tax.

Timing of encashment determines everything.

Leave Encashment During Employment: Fully Taxable

While still working, if you encash leave, it's regular salary for tax purposes.

Example: Basic ₹60,000/month. Accumulated 30 days, encashing 10 days. Daily rate ₹2,000 (₹60,000 ÷ 30).

Encashment: 10 × ₹2,000 = ₹20,000

This ₹20,000 gets added to salary income. In 30% bracket? Pay ₹6,000 tax plus cess. No exemptions.

Employer deducts TDS along with regular salary. Shows in Form 16 as part of total salary.

Why fully taxable? Law provides exemption only for encashment "at retirement." During employment doesn't qualify for Section 10(10AA).

Leave Encashment at Retirement: The Exemption Kicks In

When you retire reaching retirement age, voluntary retirement, or termination (not resignation to join another job)—Section 10(10AA) provides partial exemption.

Government employees: Leave encashment fully exempt. No limits.

Private sector employees: Only partial exemption. Exemption is lowest of three amounts:

1. Actual leave encashment received
2. ₹25 lakh (absolute cap)
3. Amount calculated using specific formula

That third point the formula is complicated.

The Calculation Formula for Private Sector

For non-government employees, exempt amount is lowest of:

Amount 1: Cash equivalent of leave encashment received

Amount 2: ₹25 lakh

Amount 3: Cash equivalent of leave at credit (max 30 days/year) based on average salary of last 10 months

Breaking Down the Formula

Step 1: Calculate months of service (joining to retirement).

Step 2: Maximum eligible leave: (Months ÷ 12) × 30 days. Basically 30 days per year.

Step 3: Average salary for last 10 months (basic + DA + commission).

Step 4: Daily rate = Average monthly salary ÷ 30.

Step 5: Multiply eligible leave days by daily rate.

Whichever is lowest among the three amounts that's your exemption. Rest is taxable.

Worked Example: Private Sector Retirement

Let's say someone retires after 25 years of service. Last 10 months average salary is ₹80,000 per month. Accumulated leave at retirement: 600 days. Company pays encashment for all 600 days.

Calculation:

Leave encashment received: 600 days × (₹80,000 ÷ 30) = 600 × ₹2,667 = ₹16,00,200

Now the three amounts for exemption:

Amount 1: Actual received = ₹16,00,200

Amount 2: Statutory limit = ₹25,00,000

Amount 3: Formula calculation

• Months of service: 25 years × 12 = 300 months
• Maximum eligible leave: (300 ÷ 12) × 30 = 750 days
• But only 600 days were actually accumulated and encashed
• So use 600 days (whichever is lower)
• Average salary: ₹80,000
• Daily rate: ₹80,000 ÷ 30 = ₹2,667
• Amount: 600 × ₹2,667 = ₹16,00,200

Exemption = Lowest of (₹16,00,200, ₹25,00,000, ₹16,00,200) = ₹16,00,200

In this case, entire leave encashment is exempt. Zero tax.

Different Scenario: Exceeding the Formula Limit

Same person, but accumulated 900 days of leave instead of 600. Company pays for all 900 days.

Leave encashment received: 900 × ₹2,667 = ₹24,00,300

Three amounts:

Amount 1: ₹24,00,300

Amount 2: ₹25,00,000

Amount 3: Maximum eligible leave is only 750 days (25 years × 30). So: 750 × ₹2,667 = ₹20,00,250

Exemption = Lowest = ₹20,00,250

Taxable amount: ₹24,00,300 - ₹20,00,250 = ₹4,00,050

That ₹4 lakh gets added to income and taxed at applicable rates.

What Counts as "Salary" for Calculation

Average salary for last 10 months includes:

• Basic salary
• Dearness allowance (if it forms part of retirement benefits)
• Commission (if based on fixed percentage of turnover)

NOT included: HRA, medical allowance, conveyance, bonuses, overtime, perquisites.

This matters because using inflated salary increases exemption. Law is clear about qualifying components.

Comparison Table: Government vs Private

Resignation to Join Another Job

You resign from Company A after 8 years to join Company B. You receive leave encashment from Company A.

Is this "retirement"? No. Section 10(10AA) exemption doesn't apply. Leave encashment is fully taxable as salary.

Exemption only for retirement cessation at retirement age, voluntary retirement, or termination. Quitting for another job doesn't qualify.

Entire encashment from the old employer gets taxed.

How It Appears in Form 16 and ITR

During service: Encashment in "Salaries" under gross salary. Already in TDS calculation.

At retirement: Full amount in gross salary. Exempt portion under "Allowances exempt under section 10" referencing 10(10AA). Net taxable after exemption in total salary.

In ITR, report gross salary including full encashment. Claim exemption under Section 10(10AA) in exemptions section. Provide calculation if amount is significant.

Common Mistakes People Make

Claiming exemption on mid-career encashment: During service = fully taxable. No exemptions.

• Wrong salary components: Including HRA or bonuses when only basic + DA + commission qualify.
• Service period errors: Using calendar months instead of completed months. 25 years 7 months = 307 months, not 26 years.
• Missing documentation: Keep appointment letter, last 10 months' salary slips, retirement order.
• Confusing with gratuity: Different exemption rules. Don't mix them up.

Tax Planning Around Leave Encashment

Not much you can do about tax on leave encashment during service. It's a salary, gets taxed like a salary.

For retirement:

• Don't accumulate beyond beneficial limits: Already at 750 days (25 years)? Accumulating more doesn't increase exemption. Excess is taxable.
• Consider timing: Retiring in one year vs next might affect overall tax bracket.
• Coordinate with other retirement income: PF withdrawal, pension, gratuity hit same year. Plan to minimize total impact.
• Maintain documentation: Prove service period and salary structure. You'll need it for claiming exemption.

Conclusion

Leave encashment taxation isn't as complicated as it first appears, but details matter. During working years, accept it's fully taxable. Can't do much about that.

Real planning opportunity comes at retirement. Understanding the formula, knowing what goes into average salary, maintaining documentation—these directly impact tax.

Timing matters too. Close to retirement with massive accumulated leave? Talk to HR and a tax consultant. Might be ways to structure things better.

Remember the three amounts. Calculate all three. Take the lowest. That's your exemption. Excess gets taxed. Not complicated once you've done it, but worth getting right we're talking substantial amounts representing years of service.

Get professional help if numbers are large or situation is complex. Cost of good tax advice is way less than the cost of getting this wrong.

Frequently Asked Questions

Q1: Got leave encashment of ₹8 lakh while still employed after 20 years of service. Can any exemption be claimed since the leave was accumulated over many years?

No exemption applies. Leave encashment received during the period of service—regardless of how many years of service or how long the leave was accumulated—is fully taxable as salary under "Income from Salaries." Section 10(10AA) exemption only applies to leave encashment received at the time of retirement, which means cessation of employment due to retirement age, voluntary retirement, or termination. Resignation to join another employer also doesn't qualify. The entire ₹8 lakh gets added to your taxable salary for the year, and TDS will be deducted accordingly. Your employer should include this in your Form 16 as part of gross salary.

Q2: Retired after 30 years with ₹30 lakh leave encashment. How is the ₹25 lakh limit applied—does it mean ₹5 lakh is automatically taxable?

Not automatically. You need to calculate all three amounts and take the lowest. If your leave encashment is ₹30 lakh, yes that's Amount 1. Amount 2 is ₹25 lakh statutory limit. But Amount 3 depends on the formula: maximum eligible leave (30 years × 30 days = 900 days, but if you actually accumulated more, still use only 900) multiplied by your average daily salary for last 10 months. If that formula gives you, say, ₹22 lakh, then exemption is ₹22 lakh and ₹8 lakh is taxable. If the formula gives ₹28 lakh, then exemption is capped at ₹25 lakh and ₹5 lakh is taxable. Calculate the formula amount before determining taxability.

Q3: Working in a government undertaking but not a government employee—are the same full exemption rules applicable?

Depends on the exact nature of employment. If you're a government employee as defined under the Income Tax Act (Central Government, State Government, local authority employee), full exemption applies with no limits. However, if you work for a PSU (Public Sector Undertaking) like BSNL, ONGC, or similar entities, you're typically treated as a non-government employee for tax purposes. In that case, the ₹25 lakh limit and formula calculation apply just like private sector employees. Check your Form 16 or consult your HR—they'll know how your category is treated for tax purposes. Government "undertaking" doesn't automatically mean government "employee" for leave encashment exemption.

Q4: Resigned from one company after 12 years and joined another. Later retired from the second company after 15 years. How is leave encashment calculated for the first job vs the second?

Leave encashment from the first company (resignation to join another job) is fully taxable with no exemption—not considered "retirement" under Section 10(10AA). That entire amount is taxable as salary in the year received. For the second company, when you actually retire (cessation of employment), Section 10(10AA) exemption applies. The calculation uses only your service period with the second company (15 years), not the total 27 years across both employers. Maximum eligible leave for exemption is 15 × 30 = 450 days. Average salary is last 10 months with the second employer. The exemption is the lowest of actual amount, ₹25 lakh, and the formula amount based on 15 years service. Service periods are not combined for leave encashment exemption purposes.

Q5: Company paid leave encashment in installments over three months spanning two financial years. How is the exemption calculated and which year's return should it be shown in?

Leave encashment is taxable in the year it's actually received, not when it accrues. If ₹20 lakh was paid in March 2025 and ₹10 lakh in April 2025, the ₹20 lakh is taxable in FY 2024-25 (AY 2025-26) and ₹10 lakh in FY 2025-26 (AY 2026-27). For exemption calculation under Section 10(10AA), calculate the total exemption you're eligible for (based on the lowest of three amounts for your entire service), then apply it proportionately to each payment based on the ratio. So if total encashment is ₹30 lakh and total exemption is ₹25 lakh, then 83.33% is exempt. Apply that percentage to each installment. Get a written calculation from your employer or CA to maintain consistency across years if questioned during scrutiny.