Leave Encashment: Understanding the Tax Implications

Leave encashment is a common benefit offered by employers, allowing employees to encash their unused leave days either during their employment or upon retirement or resignation. While this can provide a financial cushion, it is essential to understand the tax implications associated with leave encashment, as it directly affects your take-home amount.

The taxation of leave encashment differs based on several factors, including whether the employee works in the public or private sector, the timing of the encashment, and whether it is received during service or at retirement. While government employees may enjoy full exemption from tax on leave encashment, private sector employees face certain limits and conditions.

In this article, we will explore the tax rules governing leave encashment under the Income Tax Act, explain how exemptions are calculated, and help you navigate the complexities of claiming tax benefits on your encashed leave.

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Table of Contents

What is Leave Encashment?

Types of Leaves for Salaried Employees

Leave Encashment Process

Is Leave Encashment Taxable?

Calculation of Leave Encashment Exemption

Conclusion

Most Asked Questions

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What is Leave Encashment?

Every salaried individual is entitled to a minimum amount of paid leave each year as per labour law. It is not required, though, for a single employee to take all of the leave to which he is entitled in a given year. Actually, the majority of firms provide their workers the choice to roll over any unused paid time off. When the person retired or resigned from the company, whichever came first, they would inevitably have accrued unused leave balance. This forces the business to reimburse the workers for any unused paid time off. Leave encashment is a more popular term for this idea.

Types of Leaves for Salaried Employees

Casual Leave: The employee most frequently takes advantage of this kind of absence. You may take this leave of absence for no more than seven days. That may vary depending on the employer's requirements, though, as they differ for every organisation. The employee must give advance notice to the employer of any planned casual leave, including the number of days or length of the leave. If it may be carried forward in accordance with business strategy, it will be taken into consideration for leave encashment.

Medical Leave: If an employee is sick and unable to work under regular circumstances, they take this leave. To take time off, they must notify their employer. The number of paid medical leaves that an employee is eligible for varies depending on the organisation. Since this is a type of emergency leave, the employee is not required to notify the employer in advance of the leave. In addition, if the employee has been on medication for a longer amount of time, they must give the company a current medical certificate. This is not eligible for encashment of leave.

Privilege Leave: The employee can obtain this leave by giving the employer advance notice of the leave. The employer approves and pays for the leave. The worker can save up and redeem these leaves at a later time if they are not used. All organisations, however, have their own set of policies concerning the encashment of privilege leave.

Maternity Leave: Pregnant female employees receive it while they are employed. From weeks twelve to twenty-six, paid leave is granted during pregnancy. Additionally, the company grants a longer leave extension that lasts for the next sixteen months, although it is unpaid. During the leave term, no deductions are taken from the leave salary account. This is not eligible for encashment of leave.

Paternity Leave: This leave is specifically offered to staff members who become fathers. However, in India, paternity leave benefits are solely available to government employees. Before or after the birth of a child, the parent employee may be allowed a period of 15 days of leave. Moreover, the leave may be used for up to six months following the child's birth. This is not eligible for encashment of leave.

Holiday Leaves: Employees are awarded holidays, and their salaries are not withheld during these times. Each employer has a different maximum amount of vacation time.

Sabbaticals: Workers can take time off to advance their careers and broaden their knowledge. They can sign up for a course, and their company will pay back those leaves for that duration.

Leave Encashment Process

Employees can exchange their unused paid leave days for cash through leave encashment. Depending on the company's leave policy, the exact procedure may differ, but the following is a broad summary: 

Step 1: At the end of the year, the employee has a specific quantity of unused leaves that can be redeemed.

Step 2: The employee makes a formal request, which could entail sending HR a written request or completing a leave encashment form.

Step 3: The encashment amount will be determined by the HR department in accordance with your business's policies. This usually entails multiplying the number of days being cashed by your daily paycheck, which is made up of basic pay and dearness allowance.

Step 4: Depending on operational requirements and your remaining leave balance, your manager or HR may need to approve the request.

Step 5: Depending on business policy, the encashment amount will either be paid out separately or included in your final compensation after it has been approved. If required, taxes are also subtracted from this final payment.

Is Leave Encashment Taxable?

Any leave may be redeemed while still in employment, at retirement, or upon resignation. It becomes part of the salary income and is fully taxed when cashed within the service period. However, Section 89 of the Income Tax Act provides for limited relief.

Taxability of Leave Encashment During Employment: 

Encashed leaves that are deposited while the worker is still on the job are taxable since the encashed money is added to the "income from salary" head. This head is subject to Section 89 tax benefits, and employees can claim tax reduction by completing Form 10E. . This form is to be filed before filing the Income Tax Return.

Taxability of Leave Encashment After Retirement or Resignation:

The employee may use their accumulated paid leave for encashment on retirement or resignation. Nonetheless, different circumstances vary according to the kind of company the worker has been employed by. 

• The employee is eligible to have their paid leave fully encashable and totally tax-exempt if they have worked for a federal, state, or local government agency.

• Legal heirs of an employee who passed away before their leave is fully encashable may do so on the individual's behalf. They will not be assessed income tax on the amount they receive.

• When retiring or quitting, workers in the non-government or private sectors are eligible to get paid leave encashment. The highest tax exemption amount for leave encashment was Rs 3,00,000; this was raised to INR 25,00,000 in the New Finance Budget 2023; any sum beyond this threshold is subject to taxation. Exempt leave encashment is calculated in accordance with Section 10(10AA).

Calculation of Leave Encashment Exemption

The following table shows the taxability of leave encashment for different employees:

However, one may also use a leave encashment calculator for determining the taxability.

Government employees' leave encashment is tax-free. Private employees' leave encashment consists at least of the following: 

• Amount of leave encashment received 

• The government's maximum sum, which is 25,00,000 

• The last ten months' basic pay and DA 

• Pay per day*unused vacation time (given a maximum of 30 days off annually) for each year of service successfully completed

Illustration:

Following twenty years of employment with a private company, X retired. When he retired, he was paid a base income of Rs. 1,20,000. X's employer permitted him to take up to 20 paid vacation days annually. He only utilised 50 of the 400 days of paid leave in total, meaning that 350 days remained unused when he retired. Taking into account that at the time of his departure, X had received an actual payment from the company of Rs. 14 lakhs. For the past ten months, his average compensation has been (Rs. 1,20,000 X 10) = Rs. 12 Lakhs. 

The unutilized leave for each year of service is multiplied by the wage per day to determine the cash equivalent of unused leaves. There is a 30-day annual maximum for leave. The cash equivalent of Praveen's unused leave will be: ((30,000 X 20) - 200) X (1,20,000/30) equals Rs. 16 Lakhs. 

Encashed amount = (1,20,000 / 30) X 350 = 4,000 X 350 = Rs. 14,00,000

Based on the calculations under Section 10(10AA)(ii), X's encashment amount is only partially exempt from tax because he is a non-government employee. We must now determine the exemptions that apply to his encashed sum.

Tax exemption will be the least of the following amounts: 

• The sum that the government has announced = Rs 25 lakh

• The real encashment of leaves = Rs 14 lakh

• The ten-month average income = Rs 12 lakh

• Cash equivalent of unused earned leave= Rs 16 lakh

The lesser value is deducted from the lump sum that the organisation provides to determine the taxable amount. The taxable leave encashment in X's instance is Rs. 14 lakhs- Rs. 12 lakhs. The entire sum of Rs. 2 Lakh that X has encashed from his taxable leave would be added to his salary income section and taxed based on the tax slab that he is subject to.

Conclusion

Employees are qualified for paid leave upon reaching a predetermined number of service hours. Employers typically have the last say over whether paid time off can be cashed in or carried over to the next year. A person can plan their taxes by determining whether it is better to encash leave each year or to receive a lump sum payment upon retirement or resignation, depending on their income and the employer's leave encashment policy. When making a decision, one may also take inflation into account.

FAQ

Q1. Is leave encashment taxable?

Encashment of leaves is taxable. However, different industries and employers have different tax laws.

Q2. Has the leave encashment limit changed in 2023?

Yes, for non-government employees, one of the exemption criteria limitations has been raised from Rs 3 lakh to Rs 25 lakh. 

Q3. What is the maximum number of leaves an employee can encash?

Each employer has a different limit on how many leaves can be cashed. To learn more about this, be sure to review the leave policy that your employer offers.

Q4. Can casual leaves, sick leaves, etc., be encashed?

Although it largely depends on the company's leave policy, casual leave can be redeemed. This also holds true for various types of leaves, including ill leaves. To find out more about your company's leave encashment policy, get in touch with HR.

Q5. Is leave encashment after termination taxable?

After termination, leave encashment may be subject to taxes. The specific tax treatment is determined by the laws of your nation and the policies of your business. For further information, it's advisable to speak with a tax expert or your HR department.

Q6.  How much leave encashment is tax-free for employees at the time of retirement?

The New Finance Budget 2023 increased the maximum tax exemption amount for leave encashment from Rs 3,00,000 to Rs 25,00,000. Any sum over this cap is subject to taxation. Section 10(10AA) rules are followed in the leave encashment computation for exempt leave encashment.

Q7. How can I claim tax exemption for leave encashment?

When a worker is granted leave encashment while they are employed, the whole sum of such leave is completely taxable and falls under the heading of "Income from Salary." However, Section 89 of the Income Tax Act grants you significant tax benefits. It is necessary to fill out Form 10E in order to claim tax relief for leave encashment.

Q8. How much tax do I have to pay on leave encashment?

When an employee resigns from their job and receives leave encashment from their employer, it is exempt from taxes as long as it follows the guidelines for leave encashment computation and limits. It's crucial to remember that any leave encashment that a person takes while continuing to work for the same employer is taxable.

Q9. What are leave encashment rules for private companies?

For every year of service, the exemption for leave encashment cannot be more than thirty days for the employees of private companies. It also can't be longer than ten months. Based on the average wage drawn during the ten months prior to retirement, the exemption is determined.

Q10. What is Section 10(10AA) of the Income Tax Act?

The Income Tax Act's Section 10(10AA) allows for an exemption on leave encashment that employees receive upon retirement or superannuation.