Leave Encashment Tax Exemption - Section 10(10AA)

Leave Encashment Tax Exemption under Section 10(10AA) provides a significant financial benefit for employees during key career transitions such as retirement or resignation. This section outlines the rules and exemptions governing the taxation of leave encashment, offering individuals a structured framework to understand and optimise their financial outcomes.

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**2023 BUDGET UPDATE:

The Union Budget 2023-24 has significantly increased the tax exemption limit for leave encashment for non-government salaried employees from Rs. 3 lakh to Rs. 25 lakh.

What is Leave Encashment?

Leave encashment is the process of converting unused or accumulated paid leave days into a monetary benefit paid to the employee. It's like getting compensation for the leave you didn't take. Here's a breakdown of the key points:

What it is:

  • An option offered by some employers is to compensate employees for their unutilised paid leave.

  • Usually occurs at the time of retirement, resignation, or termination of employment.

  • It can also be encashed during service in some organisations, though it might be taxed differently.

What are the Different Types of Leaves?

Companies recognise the importance of providing various types of leaves to address the diverse needs of their workforce. Below are the different types of leaves available: 

  1. Casual Leave (7-10 days):

    • Flexible leave for personal reasons.

    • Encashment varies among companies.

  2. Earned Leave/Privilege:

    • Requires prior notice.

    • Eligible for encashment per organisational policy.

  3. Medical Leaves:

    • For health-related reasons.

    • The maximum limit varies from one company to another.

  4. Holiday Leaves:

    • Granted by employees.

    • No salary deduction; limits apply.

  5. Maternity Leaves:

    • Exclusive to female employees.

    • 12-26 weeks; no encashment.

  6. Sabbaticals:

    • Sabbaticals offer employees the opportunity to take extended leaves for upskilling and knowledge expansion. 

    • Employer reimbursement during leave.

Taxation of Leave Encashment During Employment Period

Leave encashment received during the employment period is fully taxable in India under your income from salary. However, some tax benefits are available through Section 89 of the Income Tax Act, 1961.

  1. Taxability:

    • The entire amount of leave encashment you receive during employment is added to your income and taxed as per your applicable tax slab.

    • There is no exemption available under Section 10(10AA) for leave encashment during service.

  2. Tax Relief through Section 89:

    To claim tax relief under Section 89, you need to fulfil the following conditions:

    • You must have been in continuous service with the same employer for at least 5 years before the year in which you received the leave encashment.

    • The leave encashment amount should not exceed the salary of the month in which you receive it.

  3. Claiming Tax Relief:

    • You can claim tax relief under Section 89 by submitting Form 10E along with your income tax return.

    • Form 10E can be downloaded from the income tax department website and filled online.

The taxation of leave encashment after retirement or resignation in India depends on whether you're a government employee or a private sector employee:

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Taxation of Leave Encashment After Retirement or Resignation

The taxation of leave encashment after retirement or resignation in India depends on whether you're a government employee or a private sector employee:

  1. Government Employees:

    • Leave encashment received by central or state government employees at the time of retirement or resignation is entirely tax-exempt, regardless of the amount.

    • In the case of an employee's death before the leave encashment, their legal heirs can receive total leave encashment on behalf of the deceased. No income tax will be charged on the amount received by them.

  2. Private Sector Employees:

    Leave encashment received by private sector employees is partially exempt and taxable, with tax calculations based on Section 10(10AA) of the Income Tax Act.

    • Exemption Limit: The maximum amount of leave encashment that can be exempt from tax is ₹25 lakhs (as of Budget 2023-24). Earlier, it was ₹3 lakhs 

    • Taxable Amount: The portion exceeding the exempt amount is taxed as per your regular income tax slab.

What is Section 10(10AA) Under Income Tax Exemption?

  • Any amount received as leave encashment during employment is fully taxable, but employees can claim tax relief under Section 89 of the Income Tax Act.

  • Leave encashment at the time of retirement:

    • Central and State Government employees enjoy full exemption.

    • Others are exempt up to the average salary of 10 months, including basic salary, dearness allowances, and commission.

  • Non-government employees are limited to a maximum of 30 days of leave per year for calculating the exempted amount during retirement or resignation.

  • Legal heirs of deceased employees receive leave encashment without tax deduction.

  • In cases of resignation or termination, government and non-government employees must pay tax on the leave encashment amount, treated as income from salary, at the applicable income tax rate.

Example of the Leave Encashments

Rohan, after 20 years of service, retired with 365 days of leave. His monthly salary was ₹30,000. Upon retirement, he received a leave encashment of ₹365,000.

Taxable leave encashment: Actual amount received (₹365,000)

Exemption under section 10(10AA): Least of A, B (i, ii & iii)

  • Average Salary of 10 months: ₹300,000

  • 30 leaves per year allowed: ₹6,00,000

  • Maximum Allowed: ₹25,00,000

Exempt amount: Lower of all (₹300,000)

Taxable leave encashment: ₹65,000 (₹365,000 - ₹300,000)

Conclusion

Leave encashment serves as a valuable benefit for employees, providing financial flexibility during key life transitions such as retirement or resignation. While government employees enjoy tax-free leave encashment, those in the private sector benefit from exemptions under Section 10(10AA). Seeking professional advice ensures a smooth process, allowing individuals to maximise savings and navigate tax implications effectively.

FAQ's

  • Can Leave encashment be retained?

    Leave encashment can be retained if the taxpayer is not undergoing any criminal proceedings or departmental investigations at the time of retirement.
  • Is leave encashment subject to taxation upon resignation?

    Leave encashment is taxable when received upon resignation.
  • What is the exemption limit for leave encashment under Section 10(10AA)?

    The income tax exemption under Section 10(10AA) cannot exceed Rs. 25 lakh, considering any prior tax exemptions granted under the same section in previous years.
  • How is leave encashment computed?

    For private sector employees, the calculation involves the amount received, the government's maximum limit, the last 10 months' basic salary and DA, and the product of daily salary and unutilised leave days (maximum 30 per year) for each completed year of service.
  • How is leave encashment taxed for non-government employees post-retirement or resignation?

    Leave encashment for non-government employees is partially exempt and partially taxable, with taxation determined according to the guidelines in Section 10(10AA)(ii) of the Income Tax Act.
  • Are leave encashment and leave salary the same?

    Leave Salary constitutes a component of leave encashment, accumulated over time and redeemed later.
  • What is the maximum number of leaves that can be encashed?

    Employees can encash leaves in the subsequent year, with the quantum not exceeding 50% of earned leaves at credit or 30 days of earned leave, whichever is less.

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