Tax on Leave Encashment for Government and Private Employees

Employees accrue various types of leave during their service, such as sick, casual, maternity, and earned leave. Unused leave can often be carried forward or encashed depending on the employer's policies. Leave encashment refers to exchanging unused leave for cash, and the tax treatment of this income depends on the type of employer (government or non-government) and the circumstances of the encashment.

This article explains the concept of leave encashment, the tax implications for different employee categories, and the exemptions available under the Income Tax Act.

What is Leave Encashment?

‘Leave encashment’ is when an employee exchanges their unused leave for cash, either during their service, upon retirement, or resignation. The income generated from leave encashment is considered part of the employee's salary and is taxable unless eligible for exemptions under specific sections of the Income Tax Act.

Tax on Leave Encashment

The taxability of leave encashment depends on whether the employee works in the government or private sector:

1. For Private Sector Employees

• Leave encashment during employment is fully taxable.

• Upon retirement or resignation, it is partially exempt under Section 10(10AA) of the Income Tax Act, subject to limits.

• The exemption limit for non-government employees has been raised to ₹25 lakhs per financial year, as per Budget 2023, from the earlier limit of ₹3 lakhs.

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2. For Government Employees

• Leave encashment for employees of Central or State governments is entirely tax-exempt, whether during retirement or otherwise.

Tax Exemption on Leave Encashment

For Private Sector Employees

Private-sector employees can claim tax exemptions under the following conditions:

1. The maximum limit for exemption is ₹25 lakhs as per Budget 2023.

2. The exemption amount is calculated based on:

   • The employee’s basic salary and dearness allowance for the last 10 months.

   • The number of unused leave days (capped at 30 days per year).

   • The total years of completed service.

     
     

Formula: Maximum Encashment Amount = [Basic Salary + Dearness Allowance] × [Daily Wage] × [Unused Leave Days (up to 30 days/year)] × [Years of Service]

For Government Employees

Encashment of unused leave is 100% tax-free for Central or State government employees.

For Deceased Employees

If the leave encashment amount is paid to the legal heir of a deceased employee, the entire amount is tax-exempt.

Tax on Leave Encashment During Service

When an employee receives leave encashment while still employed, the entire amount is taxable as ‘income from salary.’ However, the taxpayer can claim relief under Section 89 of the Income Tax Act by submitting Form 10E on the Income Tax Department portal.

Key Points to Remember

1. Government vs Private Sector Rules

   • Government employees enjoy a complete tax exemption.

   • Private employees have a higher exemption limit of ₹25 lakhs but must calculate taxable and exempt portions separately.

2. Relief for Legal HeirsAny leave encashment received by the legal heirs of a deceased employee is entirely tax-free, regardless of the employer type.

3. Tax PlanningFor private employees, understanding and utilizing the ₹25 lakh exemption limit is crucial when planning for retirement or resignation.

Conclusion

Leave encashment provides a monetary benefit for unused leave days, but its tax treatment varies significantly between government and private sector employees. Understanding the exemptions and how they apply can help individuals manage their tax liabilities effectively, especially during retirement or job transitions.