Understand in depth the taxation on leave encashment to help you with leave encashment exemption legally and rightfully. We discuss practical examples in this article to make the calculations super simple for you. Let's dive in!
Overview:
You might be missing out on some extra income every year if you haven’t heard about leave encashment yet. You would already be familiar with the fact that a salaried employee is entitled to some paid leaves during his tenure of service by the Government’s labour laws and the organisation he works for. But, what if one does not utilise all those paid leaves? Would the leaves just vanish at the end of the year? If that was the case, it would be beneficial for almost every employee to take those leaves even if he does not need them, thus leaving the company short on the workforce at the end of every year. That would be disastrous! Luckily, the concept of Leave encashment exemption saves the day.
What is Leave Encashment?
An employee who did not utilise all his paid leaves gets paid for the unutilised leaves at the end of the year. This concept is called leave encashment. Most employers also provide an option to carry the leaves to the next year. This way, the employee gets paid for the total unutilised leaves during his tenure at his retirement or when he leaves the company.
Why would anyone not just cash out by the end of the year and wait for their retirement? Understanding the tax structure of leave encashment will help us answer this question. So let’s dive deep into it.
Taxation of Leave Encashment
The taxation on leave encashment is done by adding it to ‘income from salary’ after considering all the exemptions depending on the nature of the job, when the encashment was claimed, etc. Leave encashment, done during the tenure of service before retiring from the organization, is fully taxable as income from salary. However, some exemptions can be claimed under Section 89. Thus, taxation might make one think about encashing leaves on retirement rather than annually.
Note: One must also consider inflation when deciding whether to encash on retirement or end of every year.
Leave Encashment Taxation on Retirement/Resignation
- The category of the employee determines whether his income from leave encashment is non-taxable, partially taxable, or fully taxable
- In the case of a government or state employee, leave encashment on retirement or resignation are fully exempt
- Leave encashment claimed by the legal heir of a deceased employee is also fully exempt from taxes
- Leave encashments on the retirement of a salaried employee are not fully exempt by the Government. They are taxed under income from salary after relief under Section 10(10AA)(ii).
Let’s discuss the taxation and relief of leave encashment on the retirement of a salaried employee with an interesting example. Before that, let us look at the formula for exemption.
The lower of the following are exempt from tax:
- The amount notified by the Government is ₹3 lakh.
- Actual leave encashment amount
- The average salary for the last 10 months
- Salary per day * unutilised leave (allowed upto a maximum of 30 days leave per year) for every year of completed service.
Leave Encashment: Practical Example
Mr XYZ is retiring from company A after 10 years of service. His salary at the time of retirement is ₹30000 monthly, which is ₹1000 per day. Say his company allows him 30 paid leaves every year. That means 30 * 10 = 300 paid leaves in his tenure. If he used only 50 leaves in this period, he is left with 250 paid leaves.
The total amount he is to get on retirement is thus 250 days * ₹1000 per day = ₹2.5 lakh.
Now, let’s calculate his exemption:
We take the minimum of the following,
- Amount notified by the Government – ₹3 lakh
- Actual leave encashment amount – ₹2.5 lakh
- Average salary of last 10 months – 10 * 30000 = 3,00,000 rupees
- Salary per day * unutilised leave (allowed upto a maximum of 30 days per year) for every year of completed service – (₹30000/30 days) * 250 leaves = 1000 * 250 = ₹2.5 lakh.
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So, we get the total exemption of ₹2.5 lakh as it’s the minimum of all the cases. We see that Mr XYZ did not need to fill a single rupee as the tax on his leave encashment amount even after retiring from a private firm.
Now let’s expand the problem to get a better insight into a more real-world problem where the whole amount might not get exempted.
Mr XYZ, after retiring from company A, joined company B, where he completed his tenure of 10 years with his monthly salary at the time of retirement being whooping ₹1.5 lakh (₹1.5 lakh/30 = ₹5000 per day). His company gives him 25 paid leaves every year, of which he used 15 on average. That is, out of 25 * 10 = 250 paid leaves, he used 15 * 10 = 150 paid leaves, leaving him with 100 paid leaves for encashment on his retirement.
The total amount he now is to receive 100 paid leaves * ₹5000 per day = ₹5 lakh
The total exemption is now the minimum of:
- Amount notified by the Government- ₹50,000 (Mr XYZ has already used exemption of up to ₹2.5 lakh for his tenure in company A out of a total of ₹3 lakh notified by the Government)
- Actual leave encashment amount – ₹5 lakh
- The average salary for the last 10 months – ₹1.5 lakh * 10 = ₹15 lakh
- Salary per day * unutilised leave (allowed upto a maximum of 30 days leave per year) for every year of completed service – ₹5,000 per day * 100 unused paid leaves = ₹5 lakhs
As the minimum of the above cases is just ₹50,000 thousand, out of the total cash encashment of ₹5 lakh. Mr XYZ has to pay taxes on ₹4.5 lakh by adding it to his ‘income from salary, with ₹50,000 being completely tax-free.
Leave Encashment Exemption: Types of Leaves
The company’s leave policy outlines various types of leaves, which can vary between different companies. Here are the typical categories of leave encashment taxable available to employees:
- Casual Leave: Employees can take 7 to 10 days of casual leave for personal reasons, but the rules for encashment vary from one company to another
- Earned Leave or Privilege Leave: Employees may use earned leave with prior notice, and eligibility for encashment depends on the organisation’s policy
- Medical Leave: When employees are unable to work due to health issues, they should inform their employer. The maximum allowable medical leave varies by company
- Vacation Leaves: Employees are granted Paid vacation leaves without salary deductions, and the maximum number of such leaves varies from one company to another
- Maternity Leave: Maternity leave, lasting from 12 to 26 weeks during pregnancy, is available exclusively to female employees. It cannot be encashed, and no payment is made for any extension of this leave
- Sabbaticals: Employees can take sabbaticals for upskilling and education. The employer may reimburse leaves during this period for courses or educational pursuits.
Leave Encashment Calculation
Let’s understand the leave encashment exemption with an illustration:
Proposed limit increase from ₹3 lakh to ₹25 lakh has been incorporated.
| Details | Information |
| Years of Service | 15 years |
| Entitled Paid Leave per Year | 35 days |
| Total Entitled Paid Leave | 525 days (35 days * 15 years) |
| Utilized Paid Leave | 200 days |
| Unutilized Paid Leave | 325 days (525 days – 200 days) |
| Basic Salary plus DA | ₹33,000 per month |
| Daily Salary | ₹1,100 (₹33,000 / 30 days) |
| Leave Encashment Received | ₹3,57,500 (325 days * ₹1,100) |
In this instance, the term ‘salary’ encompasses the basic salary, dearness allowance, and commission, which is determined as a fixed percentage of the employee’s secured turnover. It’s important to note that there is a specified exemption limit of ₹25,00,000, regardless of how many times an employee receives leave encashment from various employers.
What is the Process of Leave Encashment?
Salaried employees in both government and private sectors enjoy nearly equal work benefits, including pay scale, tax deductions, and leave entitlements. Employees are required to pay income tax if their annual income exceeds the threshold set by the income tax department. Employers deduct a portion of the employee’s salary and deposit it into a provident fund (PF) account, which employees can access throughout their employment and after retirement.
Additionally, employers offer incentives and allowances such as travel, food, and accommodation during the employment period. Organisations also provide insurance policies that employees can utilise during health emergencies and access the matured amount after retirement.
Employees can carry forward unused leaves to subsequent years and later request encashment for those untaken leaves. This process, known as leave encashment, allows employees to receive monetary compensation for unused leave days, providing them with additional financial benefits.
Conclusion
Leave encashment exemption can contribute significantly to your retirement fund. It’s thus always preferable to save some money in taxes where you rightfully deserve it by using the exemptions offered by Government: https://labour.gov.in/list-enactments-ministry. Compared with the real-life examples we used in this article, you can easily calculate the benefits you are entitled to, thus maximising your funds.
FAQ
What is the specific tax exemption section for leave encashment in India?
The specific tax exemption section for leave encashment in India is Section 10(10AA) of the Income Tax Act, 1961.
How does Section 10 10AA provide exemption for leave encashment?
Section 10(10AA) provides exemption for leave encashment received by an employee on retirement or resignation from service, up to a limit of ₹25,00,000. The exemption is available to both government and private sector employees.
What does Section 10 10AA (1) of the Income Tax Act entail regarding leave encashment?
Section 10(10AA)(1) of the Income Tax Act states that the amount of leave encashment received by an employee on retirement or resignation from service shall be exempt from tax, up to a limit of ₹25,00,000.
Is there a limit to the exemption under Section 10 for leave encashment?
Yes, the exemption under Section 10 for leave encashment is limited to ₹25,00,000. Any amount of leave encashment received in excess of this limit will be taxable.
Can you provide guidance on how to file Form 10E for leave encashment relief?
To file Form 10E for leave encashment relief, you can follow these steps: Step 1: Download the Form 10E from the website of the Income Tax Department Step 2: Fill in the form carefully, providing all the required information, such as your name, PAN number, address, and the amount of leave encashment received Step 3: Attach a copy of your salary slip or leave encashment statement to the form Step 4: Submit the completed form to your employer. Your employer will then process the form and submit it to the Income Tax Department on your behalf.
What is the significance of Form 10E in income tax, particularly for leave encashment?
Form 10E is used to claim tax exemption for leave encashment received by an employee on retirement or resignation from service. The form must be submitted to the employer, who will then process it and submit it to the Income Tax Department.
Who is eligible to claim relief under Section 89 in the Income Tax Return (ITR)?
Employees who receive leave encashment during service are eligible to claim relief under Section 89 of the Income Tax Act. This relief is available to both government and private sector employees.
Could you explain what Section 89 relief entails in relation to leave encashment?
Section 89 relief allows employees to claim a deduction for the amount of leave encashment received during service, up to a limit of 30 days of salary. The relief is available only if the employee has actually earned the leave and has not encashed it earlier.
What is the time limit for submitting Form 10E for tax relief on leave encashment?
orm 10E must be submitted to the employer within 30 days from the date of receiving leave encashment.
Can you provide insight into the calculation process for leave encashment relief using Form 10E?
Determine the total leave encashment amount you received during your employment Calculate the relief available under Section 89, usually capped at 30 days' worth of your salary If your leave encashment is equal to or less than the relief limit, it remains tax-free. No tax is owed If your leave encashment exceeds the relief limit, the excess portion becomes taxable, and you must pay tax on that amount.
