Taxation of Leave Encashment on Retirement

All salaried employees are entitled to a certain number of leaves from their respective organisations. However, an employee might not be able to use all of them, and might carry forward some leaves up to his retirement. 

One can get leave encashment for these accumulated leaves on retirement, resignation or during service. When leave encashment is received during the service period, it is completely taxed and counts as salary income. However, under Section 89 of the Income Tax Act, some tax exemption is available.

Tax on Leave Encashment after Retirement or Resignation

The leave encashment on an employee’s retirement works similar to leave encashment on resignation. When an employee receives leave encashment at the resignation, the encashed amount is either fully or partially exempted. The exemption depends on the employment category, that is, whether they are a government or non-government employee.

In the case of a central or state government employee, at retirement or resignation,  the leave encashment is fully tax exempt.

However, in the case of a private sector employee, at retirement or resignation, the leave encashment is not fully tax-exempt. Here, the amount is taxable as ‘income from salary’. However some exemptions are allowed under Section 10(10AA).

Tax on Leave Encashment in Other Situations

Other than retirement, there are some other situations when you might request a leave encashment. The various taxation rules on the encashed amount have been discussed below: 

• Leave encashment while in service. 

An employee, during his/her service, can accumulate leaves which they can encash in their working period. Here, this amount of leave encashment during service forms part of ‘income from Salary’ and is fully taxable for all employees.

• Leave encashment on death.

When an employee dies, the company offers his/her accumulated leave encashment to their family. This leave encashment on death is fully exempted from tax.

What Are the Types of Leaves that One Can Encash? 

There are different types of leaves that an organisation offers its employees. Each of these leaves has different encashment and taxation rules, which have been discussed below:

• Casual leave

Casual leave is the most common type of leave taken by an employee for a maximum period of seven days. However, this can also vary between organisations depending on the guidelines set by the employer. Here, you must inform your respective employer about the duration you will be away from work.  It will be considered for leave encashment, if it is allowed to be carried forward as per company’s policy.

• Privilege leave

Privilege Leave is a paid leave that an employee can take by offering prior intimation to his/her employer. If this leave is not availed by the employee, they can further accumulate them and encash them later. However, the rules regarding privilege leave encashment can vary between different organisations.

• Medical leave

Medical leaves are paid leaves that an employee can take due to illnesses. As this leave is for an emergency situation, no prior notice is necessary from the employee to the employer. However, the number of medical leaves a company can give its employees varies per the leave policy of the organisation. you might also need to submit a valid medical certificate as proof to the organisation. These leaves are not considered for leave encashment.

• Maternity leave

Maternity leave is a paid leave that a female employee can take for pregnancy during her employment period. However, this leave is paid up to 26 weeks of pregnancy. A longer extension of 16 months is available, but in this case, the leave would be unpaid. This type of leave is not considered for encashment. 

• Sabbatical leave

When employees wish to take an extended break from work for personal or professional reasons, it is referred to as sabbatical leave. Such leaves are granted to an employee in accordance with company policies and generally unpaid.

Leave Encashment Tax Exemption under Section 10(10AA)

As per section 10(10AA)(ii), the leave encashment on retirement or resignation of a non-government employee is exempted from tax. However, the exemption can be the lowest of the following amounts. 

1. Actual leave encashed amount
2. Statutory amount – ₹3,00,000
3. Average salary per month of the last 10 months before the employee’s retirement or resignation
4. [{(1 x completed years of service) – leaves actually taken in terms of month} x average salary per month] 

Here, Average Salary = Basic + Dearness Allowance + Commission on turnover (last 10 months average from the date of retirement).

Illustration Describing Tax Exemption on Leave Encashment on Retirement

To understand tax exemption on leave encashment, you can refer to the illustration below:

Ajay has been working in ABC Ltd. for the last 25 years 9 months. The company allows 2 months leave for every completed year of service to its employees. During the job, he had availed 20 months of leave. 

At the time of his retirement on 10/8/2021, he got ₹ 1,50,000 as leave encashment. As of that date, his basic salary was ₹ 5,000 p.m., D.A. was ₹ 2,000 p.m., and the commission was 5% on turnover + ₹ 2,000 p.m. (fixed). Turnover affected by the assessee during the last 12 months was ₹ 5,00,000 (evenly). Ajay got an increment of ₹ 1,000 p.m. from 1/1/2021 in Basic and ₹ 500 p.m. in D.A.

Solution:

Computation of Taxable Leave Encashment Salary of Ajay for the A.Y. 2022-23

Working Note:

1. Completed year of service: 25 years 9 months = 25 years
2. Salary = Basic + Dearness Allowance + Commission on turnover (last 10 months average from the date of retirement)

Important Points Regarding Tax on Leave Encashment 

There are some important points that one should keep in mind regarding tax on leave encashment on retirement or other situations:

1. The computation of salary includes basic plus dearness allowance, which might also include commission on the basis of employee turnover. However, any assistance other than the dearness allowance is not added here.
2. If the employee avails leave salary during his/her employment period and avails exemption for such amount during retirement, the limit is set at ₹3,00,000. Hence, it is also known as a statutory amount.
3. The average salary can also be calculated based on the salary drawn by the employee for a period of 10 months just before his/her retirement. 
4. There are different types of retirement, such as voluntary and superannuation, on the basis of which leave encashment on retirement is calculated.
5. The amount an employee receives as leave encashment on resignation is the same as that of retirement and, therefore, charges the same amount of tax.
6. Family members do not have to pay taxes on the leave encashment they receive in the event of the employee’s death.

Final Word

Leave encashment is easily available to employees during or after their employment period. You can use this encashment amount as per your requirements. It is financially prudent to decide in advance whether to encash unutilised leaves annually on a systematic basis or receive a lump sum amount at the time of retirement or resignation. One may consider factors like liquidity needs, retirement goals, cost of inflation, time value of money, etc. so as to make an informed decision.  

Frequently Asked Questions