Govt and some private employers pay a compensation against certain unutilized leaves during your service or after retirement or resignation
Leaves encashed at the time of retirement or resignation are fully exempt for government employees
Work-life balance is important in modern times, and taking a break from work every once in a while is a great idea. Thankfully, most employers offer enough leaves over and above the mandatory holidays such as national holidays, casual and sick leaves. In fact, sometimes, you may find that even after taking a trip or two during the year, you have some leaves left at the end of the year. Most employers allow you to carry over these leaves to the next year, and some even allow you to encash them or pay a compensation against them. A few extra bucks never hurt anyone. Here’s all about encashing your leaves, if your employer allows you to do so.
“There is no separate law on leave encashment, but a lot of companies give this facility. According to the Income-tax Act, 1961, in case you get such a facility, then the maximum number of leaves you can encash in a year is 30," said Anuj Shah, chief financial planner, Wealth 360, a Mumbai-based financial planning firm.
However, there is no statutory or legal requirement for employers to offer leave encashment.
The payment you get against unutilized leaves may be taxable, depending on when you encash them.
During service: Leave encashed during service is fully taxable and gets added to “income from salary" for taxation. This is applicable for government as well as private company employees. However, if the dues are not paid in the same year in which you were entitled to the leaves but are paid in any other year when a higher tax slab is applicable to you, you are entitled to some tax relief. If the total income includes any dues from past years paid in the current year, you do not need to pay a higher rate applicable to your current slab rate if the dues are from years when you were in the lower tax slab. In short, you don’t need to pay more taxes if there was a delay in payment to you and you were in a lower tax bracket for the year you received the money. This relief is permitted under Section 89 to help you avoid additional tax burden, said Balwant Jain, a Mumbai-based tax expert. The benefit under Section 89 is admissible when you are still in service.
At the time of retirement or resignation: If you are a central or state government employee, you have good news. “Leaves encashed at the time of retirement or resignation are fully exempt for central and state government employees," said Shah. If you are a non-government employee, the amount received on leave encashment is tax-exempt based on the computation provided under Section 10(10AA) (ii) and the balance amount, if any, is taxable as income from salary.
So how does the exemption under Section 10(10AA)(ii) work? The exemption is to be limited to the least or minimum of the following: 1) Cash equivalent of unutilized earned leave (earned leave entitlement cannot exceed 30 days for every year of actual service); 2) Last 10 months’ average salary (basic salary plus dearness allowance or DA); 3) Actual leave encashment amount received; 4) ₹3 lakh, as specified by the government.
Let’s understand this through an example. Say, you are a private sector employee, have worked for 25 years and are eligible for 45 earned leaves per year or 1,125 leaves over 25 years, and earn a monthly salary of ₹25,000. You use 585 leaves over your service period, which means you can encash 540 says (1125minus 585) or 18 months of the leaves, but you receive ₹6 lakh as leave encashment at the time of leaving the company. However, since the rule of encashing a maximum of 30 days for each completed year of service applies, your earned leave eligibility is 30 days multiplied by 25 or 750 days. Since you have already utilized 585 days of leave, you are eligible to encash only 165 days (750 minus 585) or 5.5 months of leave. Here, the cash equivalent will be 5.5 months multiplied by ₹25,000 or ₹1,37,500. The tax exemption will be the minimum of 1) The amount received as leave encashment ( ₹6 lakh); 2) The maximum cap as stated by the government ( ₹3 lakh); 3) The last 10 months’ average basic salary and DA ( ₹25,000 multiplied by 10 or ₹2.5 lakh); 4) Cash equivalent of the leave balance, subject to a maximum of 30 days for each completed year of service ₹1,37,500. The least amount here is ₹1,37,500.
Remember that the remaining amount will be taxable. In this case, the taxable amount will be ₹6 lakh minus ₹1,37,500 or ₹4,62,500.
Things to remember
If leave encashment is received by the legal heirs of the deceased employee, it is fully exempt.
Also, suppose you have claimed a tax exemption of ₹1 lakh during a financial year on receipt of leave encashment after resignation, a maximum exemption of ₹2 lakh can be claimed in the future on any other resignation or retirement. According to Ashok Shah, partner, NA Shah Associates LLP, a chartered accountancy firm, “The maximum cap stated by the government of ₹3 lakh is for lifetime."
According to Wealth 360’s Shah, “These leaves can be accumulated and used in case of a critical illness in the future or family obligations such as children’s marriage." Since encashing these leaves during service is taxable, for government employees, it’s advisable to encash them after retirement. “Also, when you encash it at the time of retirement, the amount will depend on the last drawn salary, which will be the highest through your career," the planner added.
So do remember to take stock of your leaves at the end of every month if your employer encashes unutilized leaves.