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Leave encashment / leave salary – Is it taxable?

From time to time, you may encash your leaves – when they are due to expire at the end of the year, when you resign and leave a company, or when you retire.

Do you have to pay tax on the amount received from leave encashment? Is there any tax deducted at source (TDS)? Does the tax change if you are a government servant or working with a private firm?

Let’s understand what the income tax rules for leave encashment are.



You encash your leaves on mainly three occasions:

  • When the leaves are due to expire (while you are still in service)
  • When you resign from a company and leave the organization
  • When you retire (at the time of superannuation)

Whatever the reason for encashing the leaves, you get some amount in return. And consequently, there are income tax implications for this amount (also known as “leave salary”).

The income tax treatment (and benefit, if any) depends on the reason due to which the leaves are encashed. It also depends on whether you are in a government job or work for a private company.


Leave encashment while in service

Central or state government employees

The amount received from any leave encashed while you are still in service is added to your income, and is fully taxable. It is taxed as per the income tax slab applicable to you.

(To know the current income tax slabs, please read “Income Tax (IT) Slabs / Brackets and rates”)

This situation applies to encashment of leaves that would otherwise expire / lapse.

Employees of private corporations

The taxation of leaves encashed by employees of private firms while still in service is the same as that for government employees – the amount received from this is fully taxable.

Leave encashment at the time of resignation or retirement

Central or state government employees

The amount received from leave encashment is fully tax free for government employees in this case. (This exemption is available under Section 10(10AA)(i) of the Income Tax Act).

There is no upper limit or cap – the entire amount received is fully tax exempt.

Employees of private corporations

The situation is not so rosy for employees or private firms!

The amount exempt from income tax is the minimum of the following:

  • The amount actually received from leave encashment
  • The cash equivalent of leaves available in your account (leave balance) (not exceeding 30 days per year of actual service)
  • Last 10 months’ average salary
  • Rs. 3 Lakhs

Please note that the tax exemption is allowed for the least / lowest of these four.

Please also note that even without the consideration of other factors, the tax exemption is limited to a maximum of Rs. 3 Lakhs.


Some clarifications

Average Salary

Here, salary would include your basic, dearness allowance (DA) and any commission received by you as a fixed percentage (%) of sales or turnover.

You have to consider the average salary for the 10 months immediately preceding the month of your resignation or retirement.

Cash equivalent of leaves

For calculating this, the maximum allowable leave per year is 30 days for each year of your service in that company.

Thus, even if your company / organization allows, say, 40 days of encashable leaves every year, you need to count only 30 days per year.

The cash equivalent should be calculated depending on your company’s policy. For example, if your company pays you leave salary (leave encashment) depending on the last drawn salary, calculate this based on your last drawn salary.

Example

Your company allows 40 days of encashable leaves every year. You served from 1 Jan 2005 to 31 Dec 2008. You took 5 leaves in 2005, 15 in 2006, 19 in 2007 and none 2008.

For calculating the number of leaves for finding “Cash equivalent of leaves”, the number allowed would be:

  • 2005: 30
  • 2006: 25
  • 2007: 21
  • 2008: 30

The total would be 106 leaves, and you would find the cash equivalent for that.

Government Employee

The term government employee means an employee of the central or state government. It does not include employees of local authorities or bodies like municipal corporations or panchayats.


Retirement or Resignation?

There has been some debate regarding whether the exemption for leave encashment under section 10(10AA) is available only at the time of retirement (superannuation), or at the time of resignation as well.

Please note that this tax benefit is available both at the time of retirement and at the time of resigning from a company.

Lifetime Limit

The limit of Rs. 3 Lakhs is a lifetime limit.

That is, even if you resign from different jobs (of course, at different times), the total available exemption is capped at Rs. 3 Lakhs.

The resignations may be in the same financial years, or in different financial years.

Example

You worked for company A, and resigned from it in July 2003. You encashed leaves, and received Rs. 2 Lakhs.

You had joined company B then, and now, you resigned from company B in February 2009. You received Rs. 2.5 Lakhs for this encashment.

In this case, the maximum exemption that you can claim is Rs. 1 Lakh (Rs. 3 Lakh lifetime limit less Rs. 2 Lakhs exemption already claimed) irrespective of how much is allowable as per the 4-condition rule stated above.

Tax Deducted at Source

While paying you the amount for leave encashment, your company would deduct TDS from the amount.

Implications and saving the tax amount through Section 89(1)

When you encash accumulated leave, the entire amount would become taxable in this year – although the amount actually belongs multiple years, and not just this year.

This can greatly increasing your income tax liability, especially because most likely, the entire amount would fall in the highest tax bracket!

Is there a way out? Yes, you can get some relief using Sec 89(1).

Please read “Saving tax on leave encashment amount – Section 89(1)”.

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