Leave encashment: Here’s how it is taxed

Anand Kalyanaraman BL Research Bureau | Updated on July 28, 2020

Government employees get full tax exemption on quitting, while others get only a partial tax break

Leave and let leave — this seems to have become widespread at many workplaces in these current tough times. But the phrase has a different connotation too when it comes to employers, employees and the taxman.

Many kinds of leave

Salaried employees are often entitled to many kinds of leave such as casual leave, sick leave and privilege leave. Depending on the employer, the rules for accumulation, utilisation and encashment (conversion into money) of such leave vary.

For instance, employees may be given a fixed 15 days of casual leave in a year, one day of privilege leave for every 11 days worked in the earlier year, and 30 days of sick leave in a year. This could vary across employers.

Generally, casual leave that accumulates in a year but is not utilised within the year lapses without the benefit of carry-forward or encashment — that is, such unutilised casual leave goes waste. In such cases, it makes sense to use your casual leave fully during the year.

Also, many employers do not allow unutilised sick leave to be encashed. Unutilised sick leave may be allowed to be carried-forward but this could come with a cap on the total days you can accumulate over the years, say, a maximum of 45 or 60 days or more.

Privelege leave, also known as earned leave, is a key benefit for employees. Employers usually allow carry forward of unutilised privilege leave. But there could be a cap on overall accumulation of privilege leave over the years, say, 90 days or 180 days or more. Also, a portion, say, 15 days of the unutilised privilege leave is often allowed to be encashed every year. Some employers show such entitlement of annual leave encashment as part of the cost-to-company of employees. Besides, if you have unutilised privilege leave when you retire or resign, these could also be encashed.

The leave encashment amount is usually calculated on the basis of your latest monthly basic salary and dearness allowance (DA) amounts. The leave encashment could be taxable, depending on when it is encashed and the employee type — government or non-government.

Taxability - common rules

If you encash leave while continuing in the job, say, at the end of each year, the amount is fully taxable at slab rates across all employee categories — government and non-government. On the other hand, if the leave encashment amount is given to nominees or legal heirs on the death of the employee while in service, the amount is fully exempt from tax across all employee categories — government and non-government.

Different tax treatment

But when it comes to leave encashment on retirement or resignation, the tax treatment becomes differentiated. Here, government employees pay no tax on the leave encashment amount. This can mean big savings, given that the leave encashment amount after long service can run into lakhs of rupees.

The taxman is kind to non-government employees too, but to a much lesser degree. For non-government employees, the tax break on leave encashment on retirement or resignation, under Section 10 (10AA) of the Income tax Act, is restricted to the least of the following: a) amount actually received as leave encashment b) amount prescribed by the government – ₹3 lakh c) 10 months average salary based on basic and dearness allowance in the 10 months before leaving the job, and d) cash equivalent of the employee’s leave balance, subject to a maximum of 30 days for each completed year of service.

For example, say, a non-government employee gets 45 days leave for each year of service as per his employment contract. Over 30 years of employment, he would have earned 1,350 days of leave, of which he used 780 days; so the leave balance is 570 days (19 months).

Say, the employer gives him ₹8 lakh as leave encashment. For the calculation on tax exemption, the earned leave will be restricted to 30 days for each year of service; that’s 900 days (30 days * 30 years). Deduct the 780 days leave taken from this 900 days, and the leave balance will be 120 days (four months).

If the average monthly basic plus DA in the 10 months before leaving service is ₹40,000, the tax exemption will be the least of the following amounts: 1) ₹8 lakh (amount received) 2) ₹3 lakh (amount prescribed by government) 3) ₹4 lakh (10 months average monthly salary of ₹40,000) 4) ₹1,60,000 (four months * average monthly salary). So, of the ₹8 lakh received as leave encashment, only ₹1,60,000 will be exempt from tax.

Tax will be applicable on the balance amount (₹6,40,000) and, for a person in the 30 per cent tax slab, the tax amount will be about ₹2 lakh. Net-net, the take home leave encashment amount will be about ₹6 lakh (₹8 lakh minus ₹2 lakh).

Single limit across employers

Note that the tax exemption limit (prescribed by the government) of ₹3 lakh for non-government employees is an aggregate amount across employers. So, if you have already claimed ₹2 lakh as tax exemption on leave encashment when you left the services of an employer, you can claim only the balance ₹1 lakh when you resign or retire from future employments.

Benefit in both tax regimes

The tax exemption break on leave encashment is available under both the old and new tax regimes. Shailesh Kumar, Partner, Nangia & Co, says, “Income tax exemption for most of the allowances are withdrawn under the new alternative tax regime for individuals, who wish to avail more beneficial slabs rates prescribed u/s 115BAC of the IT Act. However, tax exemption for retiral benefits such as leave encashment and gratuity are retained even under the new tax regime, subject to limits prescribed under the IT law.”

Lay-offs also covered 

The tax break on leave encashment is available not only when an employee retires or resigns voluntarily from service - but also when an employee has to resign involuntarily, such as when he is laid off. That’s because Section 10(10AA) of the IT Act uses the words “retirement whether on superannuation or otherwise”. The word “otherwise” covers a wide gamut of severance from service.  

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Published on July 28, 2020
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