Employees get access to various benefits while joining a company. One of them is a paid leave benefit to employees which they can utilize as a leave encashment if it goes unused.
This potential benefit of converting unused leaves in exchange for cash gives an extra financial cushion to the employees. A study mentions that financial benefits help 90% of employees in improving productivity.
Therefore, there are tax implications associated with leave encashment which differs based on several factors and also on whether an employee works in the government sector or the private sector.
Well, there are tax benefits too on these implications. Employees can avail of tax exemption of leave encashment under Section 10(10AA) of the Income Tax Act, offered by the government.
The treatment varies for government and non-government employees. While government employees enjoy full tax exemptions, non-government employees are eligible for a partial tax exemption, calculated based on specific criteria.
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Budget 2024 Update: The exemption limit on leave encashment for non-government employees under Section 10(10AA) of the Income Tax Act is a generous Rs.25,00,000, offering a substantial advantage in how leave encashment is taxed in India. Earlier the exemption limit was only Rs.3,00,000 for salaried employees but the government made a spike to Rs.25,00,000 in the budget 2023 and is still the same |
This article explores leave encashment, including how it’s taxed, exemptions of leave encashment employees are entitled to, and how to maximize leave benefits.
What is Leave Encashment? (and How it Benefits)
Leave encashment is a benefit to employees where they are compensated for the unused leave they have accumulated over time. As per the labor law, every employee is entitled to a minimum amount of leave for the year which is enough for them and even goes unutilized in the given year.
The majority of companies allow them to carry forward the unused leaves to the next year. At the time of retirement or resignation, the employer reimburses them cash in exchange for the accumulated leave.
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Note: Leave encashment is typically outlined in employment contracts or company guidelines whether full or partial encashment is allowed. It can vary across organizations |
For employers, It becomes a method to compensate employees for their dedication and commitment to their roles.
Types of Leaves for Salaried Employees
Depending upon the nature of the employee’s absence, every company offers different types of paid leave. Some companies may offer additional types of leaves but here are the most common ones that every company has:
1. Earned Leave (EL)
This leave is accumulated over time by employees based on the number of days they have worked. A few companies name it as privilege leave which is often eligible to be encashed.
2. Sick Leave (SL)
As the name suggests, this is for when an employee is unwell medically and unable to work. A study by Gallup says that employees experiencing burnout are 63% more likely to take a sick day leave while 23% are more likely to go to the emergency room.
Generally, this leave is not eligible for leave encashment as it is designed for medical situations but some companies may allow employees to carry over unused sick leave to the next year.
3. Casual Leave (CL)
Every employee may need urgent attention to any unforeseen situation or a personal matter for which employers grant them casual leave for a short term. Typically, some employers do not allow casual leave to roll over to the next year or encash at the time of resignation or retirement.
4. Maternity Leave
Maternity leave is granted to pregnant female employees at the time of pregnancy or childbirth and varies in duration. It allows mothers to take time off from work to recover from childbirth.
During the leave term, companies do not make any deductions from the salary income and also offer an extended period in some cases. However, this leave is non-encashable as it is specifically designed to support employees during an important life event.
5. Paternity leave
Paternity leave is granted to male employees who become fathers. However, in India, this leave is available for only government employees or in a few private companies. This leave is also non-encashable as it is specially designed for an important life event.
What is the Process of Leave Encashment?
Through leave encashment, employers allow employees to exchange unused leave days for cash. The procedure differs depending upon the employer's leave encashment policy but here’s the common structure that the company follows:
Step 1: The employee can fill out a leave encashment form or send a request (in writing) to the company’s HR for the number of unused leaves by the end of the year.
Step 2: The human resource department will determine the leave encashment amount based on the daily payout which also includes dearness allowance and monthly commission if applicable based on the policies outlined.
Step 3: The employee’s manager or the HR is authorized to approve the request depending upon the requirements.
Step 4: After the approval, the leave encashment amount will either be compensated separately or at the time of final payout.
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Note: The company may deduct taxes from the leave encashment amount, if applicable |
Is Leave Encashment Taxable?
Leave encashment sounds like a great benefit to employees but is subject to taxation too. Therefore, the treatment varies depending on the situation, whether received during employment or at the time of retirement or resignation.
It also varies whether an employee has a government job or a non-government job. Here’s a breakdown of how leave encashment tax is treated in different situations:
Leave Encashment During Employment
When an employee encashes their unused paid leave while still employed, the amount received is treated as part of their salary income and is fully taxable.
However, employees can get leave encashment tax relief under Section 89 of the Income Tax Act. This provision allows employees to reduce the additional burden of taxation of leave encashment that comes with leave encashment.
How to Claim Tax Relief?
The employee can fill out Form 10E, available on the Income Tax Department e-portal.
Once the form is completed and submitted online, it ensures that the tax relief is applied, thereby reducing the overall tax liability on the leave encashment amount.
Leave Encashment at the Time of Retirement or Resignation
At the time of retirement or resignation, employees can encash their accumulated paid leave. The tax treatment of this leave encashment depends on the type of organization.
Private/Non-Government Employees
Employees in the private or non-government sector are eligible for partial or complete exemption on leave encashment under Section 10(10AA) of the Income Tax Act. The maximum limit is set at ₹25,00,000 as per the Finance Budget 2024. Any amount exceeding ₹25,00,000 will be taxable.
Government Employees
Employees who work in a central or state government organization are fully exempted from paying taxes on their leave encashment. This means a full leave encashment amount is received without any tax deductions.
Leave Encashment for Legal Heirs
If an employee is deceased, before encashing their leave, the legal heirs are entitled to receive the full leave encashment amount on behalf of the deceased employee. Furthermore, no taxation of leave encashment will be levied on the amount received by the legal heirs of the deceased employee.
Factors Affecting the Leave Encashment Exemption
While calculating leave encashment exemption for non-government employees, several factors are governed. Here’s the step-by-step breakdown.
- Basic Salary: The fixed part of your salary and the primary component used to calculate the exempt amount.
- Accumulated Leave: The total number of unused paid leave days that are eligible for leave encashment are accumulated leaves. For tax exemption purposes, a maximum of 30 days of leave per year of service period is considered, not more than that.
- Dearness Allowance (DA): If applicable, DA is included in the calculation as it compensates for inflation.
- Commission (if applicable): Any regular commission received as part of your salary is also considered.
- Years of Service: The number of years you’ve been working with the organization plays a key role in determining the number of leave days for which you can claim leave encashment exemption.
Leave Encashment Calculation (Exemption Formula)
The amount exempt from tax for leave encashment applies to the minimum of the following:
- Actual Leave Encashment Received: The amount of leave encashment an employee receives from the organization.
- Leave for 30 Days per Year of Service: The calculation is based on the number of years an employee has worked, considering up to 30 days of leave per year. This is multiplied by their daily salary.
- Average Salary for the Last 10 Months: Sum of Basic Salary + Dearness Allowance + Commission (if applicable), averaged over the last 10 months prior to retirement or resignation.
- Maximum Exemption for leave encashment Limit: ₹25,00,000 (as per the Finance Budget 2024).
Example of Calculating the Exempt Amount
Employee Details:
- Years of service: 20 years
- Unused leave: 500 days
- Basic salary (last 10 months average): ₹50,000 per month
- Dearness allowance: ₹5,000 per month
- Leave encashment received: ₹6,00,000
Step-by-Step Calculation:
- Actual Leave Encashment Received: ₹6,00,000.
- Average Salary for the Last 10 Months:
Basic salary: ₹50,000
Dearness Allowance: ₹5,000
Total average monthly salary = ₹50,000 + ₹5,000 = ₹55,000
Average salary of last 10 months: ₹55,000 × 10 months = ₹5,50,000 - Leave for 30 Days per Year of Service:
Number of years of service = 20 years
Leave considered for exemption = 30 days/year × 20 years = 600 days
However, the employee has 500 days of unused leave, so we’ll use that in the calculation.
Daily salary = ₹55,000 ÷ 30 = ₹1,833.33.
Cash equivalent of unused leave = 500 days × ₹1,833.33 = ₹9,16,665. - Maximum Exemption for leave encashment Limit: ₹25,00,000.
In this case, the exempt amount will be the least of these values, which is the cash equivalent of ₹5,50,000 (average salary for the last 10 months). The remaining ₹50,000 (₹6,00,000 - ₹5,50,000) is taxable.
Tips to Maximize Leave Encashment Benefits
Leave encashment can provide a substantial financial boost, particularly for an employee who retires or decides to leave a company.
However, to utilize tax benefits, a strategic approach is essential. Some practical tips below on how employees can maximize their leave encashment:
1. Understand the Company’s Leave Policy
Every organization designs its own policies on leave encashment and accumulation. Some allow employees to carry forward unused leave days into the next year, while some may cap this accumulation.
They should familiarize themselves with their company’s leave policy to ensure that they plan effectively and avoid missing out on leave encashment opportunities.
2. Plan Leave Usage Wisely
Employees must avoid using up all their paid leave unnecessarily for maximum leave encashment. While taking breaks for well-being is crucial, saving leave days for the long term, especially when retirement is near, can result in a larger leave encashment payout.
3. Know the Exemption Limits
For a non government employee, the maximum tax exemption on leave encashment is ₹25,00,000, as updated in the Finance Budget 2024. Employees should aim to accumulate leave that falls within this tax-free threshold to claim the highest possible exemption.
Any amount over ₹25,00,000 will come under the tax, making it important to plan to leave accumulation with this limit in mind.
4. Utilize Tax Relief Under Section 89
No exemption on leave encashed during employment. However, employees can reduce their tax liability by claiming relief under Section 89 of the Income Tax Act.
Filling out Form 10E through the Income Tax Department’s online portal allows employees to minimize the tax burden on encashed leave.
Key Takeaways
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FAQs
Can I use the entire limit of Rs.25,00,000 for leave encashment?
Yes, non-government employees can avail of tax exemptions up to Rs.25,00,000, however, this is the maximum limit and can be accessed only under certain conditions.
Can all types of leaves be encashed?
No, not all types of leaves can be encashed. It largely depends upon the company's policies and the type of leave.
Will I get tax exemption on leave encashment in the new tax regime?
Yes, tax exemption on leave encashment is available in the new tax regime. The provision Section 10(10AA) in the Income Tax Acts underlines the terms and conditions for availing the exemption on leave encashment.
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