Synopsis: Retirement leave encashment is another source of retirement income, but this form of income is taxable according to the category of the employee and when he gets his encashment. Whereas, government employees get total tax relief in their leave encashment, non-government employees get relief only up to a limit of ₹25 lakh subject to the limits and conditions prescribed under section 10 (10AA).
Most salaried individuals carry forward unutilized earned leaves all through their lives and cash them into a single amount. The treatment of this sum from a tax perspective is not the same for everyone. In the case of the assessment year 2026-27, it is important that salaried individuals are aware of the tax exemptions and other relevant provisions.
What Is Leave Encashment?
Encashment of Leave Entitlements refers to the payment made by an employer towards the earned but unused leave entitlements of the employees. The payment may be received during their employment period or upon their retirement,resignation, and superannuation. There is a different tax treatment depending on when the payments were made.
Is Leave Encashment Taxable?
However, when leave encashment is received during employment, then the total sum of money is considered as income from salary and is taxable. But if leave encashment is received on the date of retirement, then it is eligible to receive the tax benefit under Income Tax Act, based on certain conditions.
Tax Exemption for Government Employees
Employees of the Central and State governments get the best treatment when it comes to leave encashment. No matter what the total amount of leave encashment received by an employee during the retirement is, the total amount will be exempt from Income Tax under section 10(10AA).
Tax Exemption for Private Sector Employees
The tax-exemption for the non-governmental employees, which include both the private employees as well as employees of any public sector undertakings,is subject to specified limits under Section 10(10AA) of the Income Tax Act. The tax-exempt amount is the least of the following:
- Actual leave encashment received
- Cash equivalent of unutilized earned leave standing to the employee’s credit (earned leave cannot exceed 30 days for each completed year of service with the employer)
- Average salary of the 10 months immediately preceding retirement, multiplied by 10
- ₹25 lakh
All other amounts which exceed the eligible deduction will be liable to tax under the head “Income from Salary.”
₹25 Lakh Exemption Limit
The new exemption threshold for non-government employees was raised from ₹3 lakh to ₹25 lakh effective from April 1, 2023.Therefore, employees retiring during FY 2025-26 will be eligible for claiming the higher exemption threshold of ₹25 lakh subject to the prescribed calculation rules .
Important Condition on Earned Leave
For exemption calculations, earned leave is generally considered up to a maximum of 30 days for every completed year of service. If an employee has already used more leave than accumulated, there may be little or no eligible leave balance available for encashment. In such cases, the payment may not qualify for exemption and could become fully taxable.
How Salary Is Calculated for Exemption Purposes
For non-government employees, the tax exemption on leave encashment is partly determined using the employee’s average salary for the 10 months immediately preceding retirement, resignation, or termination of service. However, “salary” for this purpose does not include the entire CTC or monthly take-home pay. The salary considered generally includes:
- Basic salary
- Dearness allowance (to the extent it forms part of retirement benefits)
- Commission, if paid as a fixed percentage of turnover achieved by the employee
Elements like HRA, bonus, special allowance, perquisites, and contributions made by employers towards pension are normally excluded. The reason being that the limit is based on the calculation of average salary. It is therefore important for estimating the tax-free portion of leave encashment.
Reporting Leave Encashment in ITR
Taxpayers must disclose the leave encashment earned during the financial year on the salary account when they file their ITR. The tax-exempt leave encashment amount must be mentioned as per the applicable Section 10 exemption, while the taxable leave encashment will have to be disclosed under the “Income from Salary” head. It is essential for employees to check whether the leave encashment amount declared in their ITR matches the amount provided by their employer through Form 16.
Key Takeaway
Leaves encashment can be used as an important means of retiring benefits; however, it is necessary to understand their tax implications. While government servants remain eligible for full exemption on the retirement leaves encashment,non-government citizens are entitled to receive up to ₹25 lakh rupees exempt from income tax, according to certain provisions. This will help salaried citizens file their tax returns accurately in AY 2026-27.
Written by Ameet S
