Legal AdviceTaxation

Leave Encashment Exemptions and Taxation

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!

Introduction 

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. 

Taxation on Leave Encashment 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. 

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.

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. 

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. 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.

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