How much of your leave encashment is tax-free? Who gets full exemption and who doesn't: Explained

Employees can avail themselves of leave encashment, which can constitute a substantial portion of their retirement corpus. But the tax treatment varies depending on whether the employee served in the government or private sector, as well as the amount of unutilised leave accumulated over the years. Under Section 10(10AA) of the Income Tax Act, leave encashment received at the time of retirement, superannuation, resignation or other eligible separation from service qualifies for tax relief. Government employees enjoy complete tax exemption on such receipts, but non-government employees are eligible only for a partial exemption subject to prescribed limits.

Exemption available only at exit

Employees should note that tax benefits are available only when leave encashment is received at the time of retirement or separation from service. Any leave encashment received while an employee continues in service is treated as salary income and taxed according to the individual's applicable income tax slab.

Central and state government employees receive the most favourable tax treatment. Under Section 10(10AA)(i), leave encashment received upon retirement is fully exempt from income tax.

There is no monetary ceiling on this exemption. The entire amount received for unutilised earned leave at the time of retirement is exempt, making leave encashment one of the most tax-efficient retirement benefits available to government employees.

Restrictive rules for private firm employees

The rules are more restrictive for employees of private companies, public sector undertakings and other non-government organisations.

Under Section 10(10AA)(ii), the exempt portion of leave encashment is limited to the lowest of the following four amounts:

The actual leave encashment received at retirement; the cash equivalent of unutilised earned leave, calculated subject to a maximum accumulation of 30 days of leave for every completed year of service; 10 months' average salary based on the last 10 months immediately preceding retirement; or ₹25 lakh.

As a result, the tax exemption is not automatically equal to the leave encashment amount received. Employees must compare all four calculations and claim exemption only up to the lowest amount. Any excess amount is taxable under the head "Income from Salary".

₹25 lakh exemption limit offers major relief

A significant relief for private sector employees came in 2023 when the Central Board of Direct Taxes (CBDT) increased the maximum exemption limit from ₹3 lakh to ₹25 lakh with effect from April 1, 2023.

The higher threshold applies to eligible leave encashment received on retirement and can substantially reduce the tax burden for employees who have accumulated large leave balances over long careers.

However, taxpayers should remember that the ₹25 lakh exemption is a lifetime limit. If an individual has claimed leave encashment exemption from a previous employer, the available limit may be reduced by the amount already utilised.

What salary components are considered

For the purpose of calculating the exemption, salary generally includes basic salary, dearness allowance to the extent it forms part of retirement benefits, and commission where it is paid as a fixed percentage of turnover achieved by the employee. Other allowances and perquisites are typically excluded while calculating average salary for exemption purposes.

In cases where leave encashment is paid after the death of an employee, the amount received by legal heirs is generally exempt from tax, providing additional relief to the family.

Documents to keep ready while filing tax returns

Taxpayers should carefully review the leave encashment details reported by their employer. In some cases, the entire amount may be reflected in Form 16, requiring the employee to separately claim the eligible exemption while filing the income tax return.

To support the claim, retirees should retain service records, leave balance statements, salary details for the 10 months preceding retirement, and the leave encashment calculation provided by the employer. Proper documentation can help avoid disputes and ensure that the available tax benefits are correctly claimed.