Leave encashment tax relief: Eligibility and exemption limits explained

Salaried employees are entitled to a certain number of paid leaves every year, but there may be times when they are unable to utilise all of them. In many companies, unused leaves in a year can be carried forward to later years, allowing employees to accumulate a leave balance until they retire or resign from their position in the organisation.

As a result, employees often end up with a stock of unutilised leave by the time they leave their company. Instead of availing these leaves as time off, they may choose to receive monetary compensation from their employer. This payment in return of unused leave is known as leave encashment.

While leave encashment can provide an additional financial benefit, it is also subjected to tax in the hand of the employee. However, its tax treatment depends on when it is received and your employment sector (private or government). Employees may also be eligible for tax exemptions on the amount received, subject to conditions and limits under the income tax law.

How is leave encashment taxed in India?

The tax treatment of leave encashment depends on when it is received. If an employee receives leave encashment while still in service, the entire amount is taxable and is included under the head 'Income from Salary'.

As mentioned above, the tax treatment of leave encashment depends on when it is received. If an employee receives leave encashment while they are still in service, then the amount becomes fully taxable and is included under the head ‘Income from Salary' in the ITR form.

However, different tax rules apply when leave encashment is received at the time of retirement or resignation. In such cases, employees may be eligible for a partial or complete tax exemption, depending on their category.

Tax treatment of leave encashment at retirement or resignation:

• Central and State Government employees: The entire leave encashment amount is fully exempt from tax.
• Non-government employees: The amount is partly exempt and partly taxable. The exemption is calculated in accordance with Section 10(10AA) of the Income Tax Act.
• Legal heirs of a deceased employee: Any leave encashment received by the legal heir is fully exempt from tax in the hands of the recipient.

How can non-govt employees claim exemption?

For private-sector and other non-government employees, leave encashment received at the time of retirement is eligible for tax exemption under section 10(10AA) of the income tax act. However, the maximum tax exemption available on leave encashment is capped at ₹25 lakh.

If an employee receives leave encashment from more than one employer in the same financial year, the combined exemption claimed across all such payments cannot exceed this limit, according to information on income tax portal.

Other than that ₹25 lakh ceiling is a lifetime limit. Any exemption claimed on leave encashment in earlier years will reduce the balance exemption available in subsequent years. As a result, the total exemption claimed by an employee under this provision across different years cannot exceed ₹25 lakh.