Leave Encashment: Calculation & Taxation

All salaried have different type of leaves namely: Sick Leave, Casual Leave, Earned/Privilege leave, etc. If employees take lesser leaves than they are eligible for, most employers encash the left over leaves either annually or at the time of leaving the company. Of all types of leaves only earned or privilege leave is encashable.

Leave Encashment Calculation:

There is no fixed rule as how much leaves can be carried forward every year or how many leaves can be encashed. Most employers have their own rules. Usually the basic salary and dearness allowance is taken in consideration for calculation of the amount.

Tax on Leave Encashment:

The tax of leave encashment is dependent on if you are government or private sector employee, or if you are encashing it at the time of retirement or mid-way. We take each case separately.

At the time of Retirement:

Government Employee:

The entire amount received as leave encashment is tax free.

Non Government Employee:

The leave encashment for private sector employees is stated in Section 10 (10AA) and is minimum of the following 4 factors:

1. Amount received as leave encashment
2. Maximum cap as stated by government – Rs 3 Lakhs
3. Last 10 months average basic salary & dearness allowance before leaving the job
4. Cash equivalent of the leave balance, subject to maximum of 30 days for each completed year of service

We take an example to make the above calculation clear.

Rita is a non-government employee who receives Rs 6 lakh as her leave encashment at the time of retirement. She worked here for 25 years and was eligible for 45 earned leaves every year. Below is the calculation:

• No. Of earned leaves Rita was eligible for = 45 X 25 = 1,125 days
• She used 585 leaves over her service period
• Leaves eligible for leave encashment = 1125 – 585  = 540 days (18 months)
• Average last 10 months basic + dearness allowance = Rs 25,000

Tax Calculation:

The tax exemption would be minimum of the below 4 points:

• Amount received as leave encashment – Rs 6 Lakhs
• Maximum cap as stated by government – Rs 3 Lakhs
• Last 10 months average basic salary & dearness allowance before leaving the job – Rs 2,50,000 (Rs 25000 X 10)
• Cash equivalent of the leave balance, subject to maximum of 30 days for each completed year of service – Rs 1,37,500 (as per calculation below)

Earned leave eligibility as per above rule = 30 days X 25 = 750 days

Leaves used = 585 days

Leaves eligible for encashment (as per above rule) = 750 – 585 = 165 days (5.5 months)

Cash equivalent = 5.5 X 25000 = Rs 1,37,500

Tax exemption = Rs 1,37,500

Taxable component = Rs 6,00,000 – Rs 1,37,500 = Rs 4,62,500

Post tax deduction the leave encashment would vary from Rs 3.2 lakh (in the 30% tax slab) to Rs 4.15 lakh (in 10% tax slab)

At the time of Resignation:

There are differences between tax experts on the tax treatment of leave encashment at the time of resignation. Some consider it as taxable while others other consider the tax treatment same as at the time of retirement. We support the later:

The leave encashment is tax free for the government employee and the calculation is same as above for non-government employees. However the limit of Rs 3 lakh for non-government employee is for the entire lifetime.  In case you already got Rs 1 lakh while leaving your job, going forward you can only have Rs 2 lakhs as tax exempted leave encashment.

Leave encashment while in Service

If you encash leaves partially or fully while in service the income from encashment is fully taxable for both government and non-government employee.

Leave encashment on Death

The leave encashment is tax free when paid to the nominees or legal heirs at the death of employee.

Important Points:

• Leave encashment is only for completed years of service. If you have 20 years and 7 months of service, the calculation would be for 20 years only.
• There is no statutory compulsion to have Leave Encashment Policy. So your employer may or may not have leave encashment at their discretion.
• Government employees can have maximum of 10 months of leave accumulation and hence encashment