Tax on Leave Encashment for Government & Private Employees

Every employee receives certain types of leaves throughout the year till they are in a company. Popular types of leaves are sick leaves, casual leaves, ordinary leaves, maternity leaves, earned leaves and others. You can carry forward some of these leaves to the next year, depending on the type of leave and the employer’s policy. These leaves can be encashed or exchanged for a certain amount of cash, which may or may not be taxable depending on the type of service (government or non-government). 

Let us learn more about leave encashment, tax on leave encashment on retirement for PSU employees, tax on leave encashment on retirement for bank employees, Section 10(10AA) of the Income Tax Act on leave encashment tax exemption and more. 

What is Leave Encashment? 

As the term suggests, ‘leave encashment’ is an exchange of unused leaves for cash. Whether an employee has saved leaves or is retiring or quitting the job, they can use these leaves for leave encashment. 

Yes, your unused leaves can bring you income in the form of leave encashment. However, this income is also taxed under ‘income from salary’. This is unless you can claim tax relief or exemption. 

What is a tax on leave encashment? 

The income earned on your encashed leaves is taxable up to a certain limit. As per Budget 2023, non-government employees’ tax exemption on leave encashment limit is ₹25 lacs per financial year. This limit was earlier set at ₹3 lacs till 2022. This limit is different for government employees. 

Tax on leave encashment for private employees 

Leave encashment for private or non-government employees is fully taxable during their service period. They can seek to claim partial exemption under Section 10(10AA)(i). Similarly, leave encashment on retirement is partially exempted and partially taxable under Section 10(10AA)(ii) of the Income Tax Act. 

Income tax on leave encashment for government employees

There is no leave encashment exemption limit for government employees. Their entire leave encashment amount is fully tax-exempt. 

What is tax exemption on leave encashment?

Leave encashment tax exemption for private-sector employees

For private sector employees, the leave encashment exemption is ₹25 lacs as per Budget 2023. Earlier, this exemption limit was ₹3 lacs. The leave encashment exemption for tax limit has been increased to accommodate the general income increase with salary for non-government employees. 

Leave encashment exemption for government employees

Leave encashment exemption for tax for PSUs or government employees is 100 per cent tax-free. Employees employed in services with the Central or the State government can avail of this exemption.

Leave encashment exemption calculation

The upper limit, set by the government at ₹25 lacs, is calculated by multiplying the daily salary rate by the unused leave days (up to 30 days yearly) for every full year of service and then by the basic salary of the last ten months.

Formula 

Maximum Encashment Amount for Leave = [Basic Salary for the Last Ten Months + Dearness Allowance] × [Every day Wage] × [Unused Leave Days (up to a total of thirty days yearly)] × [Total Years of Completed Service]

Tax on leave encashment on retirement

Income tax on leave encashment on retirement can be partially or wholly exempted under the following conditions: 

• If you are a Central or State government employee, your encashment amount will be completely tax exempted. 
• Private companies or non-government employees can get partial tax exemption under Section 10(10AA) of the Income Tax Act. 
• If you are the legal heir of a deceased employee, the leave encashment amount would be completely tax-exempt in your hands. 

Tax on leave encashment during the service period

If an individual receives the leave encashment amount during service, the entire amount would be taxable as ‘income from salary’. The taxpayer can claim some exemption through Section 89 of the Income Tax Act by filling out form 10E and submitting it to the online Income Tax Department (ITD) portal. 

Conclusion 

Section 10(10AA) of the Income Tax Act leave encashment rules state that leave encashment is completely tax-exempt for government employees and partially taxable for non-government employees. While leaves form an essential aspect of any job, their encashment and exemptions on tax are crucial to be calculated while filing Income Tax Returns (ITR) for a financial year.