Introduction: Understanding leave encashment is crucial for employees, offering a financial cushion at retirement. This article delves into the meaning, types of leaves, tax implications, and exemption rules associated with leave encashment.

MEANING OF LEAVE ENCASHMENT

Leave is a crucial factor that enables workers to attain a robust work-life equilibrium. Leave may generally be taken by employees while they are still employed. A set number of paid leaves is provided by an organization to each salaried individual in accordance with labor rules. If the employee does not take use of this leave, it may either expire, accumulate for the future, or be allowed to be encashed annually or at the time of retirement or termination. Employees receive leave encashment, which is the sum of money they receive for any unused paid time off from their employer each year. The amount paid for the encashment of uncovered leave would be included in one’s compensation. Section 10(10AA) offers an exemption, although, with regard to the amount an employee receives upon retirement as payment for unused earned leave. Up to a specific amount, non-government employees are exempt from the leave encashment requirement. Due to the overall rise in pay income, this limit—which was set at Rs. 3 lakhs in 2002—has been raised to Rs. 25 lakhs.

TYPES OF LEAVES

Following are some types of leave

1. Maternity leave – Companies are required by the Maternity Benefit Act of 1961 to provide 12 to 26 weeks of paid leave to any pregnant woman who worked for at least 80 days the year prior. By offering such leaves companies can encourage gender equality and improve the health and wellbeing of their staff by providing maternity leave.

2. Casual leaves – Employees most commonly request casual leave for vacation, rest, family activities, and resting and unwinding. These leaves are available for a period of 7 to 10 days.

3. Medical leaves – Employees must notify their employer if they are unable to carry out their responsibilities for the organization due to medical concerns.

4. Sabbaticals – Employees might take time off to learn new skills and broaden their expertise. They can enroll in a course, and the company will reimburse them for the time they are away.

5. Earned Leave – An employee can avail of earned leaves with prior notice to the authority. These leaves become eligible for encashment after a specific period. This policy varies from one organization to another.

HOW TO CALCULATE TAXABLE LEAVE ENCASHMENT

Leave Encashment Taxable = Leave Encashment Received – Exemption calculated as per section 10(10AA).

TAXABILITY OF THE LEAVE ENCASHMENT

As per section 10(10AA) of the Income Tax Act

1. Received during the employment: – Fully taxable (For both government and non- government employee)

2. Received at the time of retirement: –

a. In case of government employees – fully exempt

b. In case of non-government employees – exemption is the lower of the followings: –

1. Leave encashment received

2. Rs.25,00,000

3. 10 months of average salary

4. leave credit in days /30 *Average salary

  • Salary Includes: – Basic + Dearness allowance (forming part of salary) +commission (if received as a % of turnover )
  • Average salary means the salary drawn by an employee during a period of 10 months preceding the date of retirement/10

Average salary = Salary for last 10 months

10 months

  • Rules to be remembered while calculating the leave credit in months

1. For leave allowed, Income Tax has a ceiling of 30 days per year

2. Consider completed no of years of service.

EXEMPTION REQUIREMENTS

Certain partial and total exemptions are available when any leave is encashed at retirement or resignation. The exemption requirements are as follows: –

1. Employees of the Central or State Government are excused from paying taxes on their leave encashment.

2. Leaves are totally exempt when a legal heir receives the encashment on behalf of a dead employee.

3. In the case of non-government employees, leave encashment is exempt based on the computation stated in Section 10 (10AA) and the balance amount if any is taxable as “income from salary”.

Let’s take a practical example for understanding this concept more precisely.

Mr M is retiring after 20 years of service.

Mr M was entitled to 35 days of paid leave per annum from his employer, i.e., overall 700 days of leave during his entire service (35*20).

Out of the same, Mr A has already utilized 260 days of paid leave and is left with 440 days of unutilized leave. Mr A was drawing basic salary + DA of Rs 33,000 per month at the time of retirement and received Rs 4,84,000 as leave encashment calculated based on 440 days * Rs. 1,100 (salary per day = Rs.33,000/30 days).

Particulars

Amount (in Rs)
Leave Encashment received 4,84,000 (440 days*1,100)
Less: Exempt 3,30,000
Least of the following:

1. Amount notified by the Government

25,00,000
2. Actual leave encashment received 4,84,000
3. Average salary for 10 months = Rs 33,000*10 months 3,30,000
4. Rs 1,100* (30 days * 20 completed years of service minus 260 days of utilized leave) 3,74,000
Leave Encashment taxable as ‘income from salary’ 1,54,000

Notes

1. Leave pay received throughout the service period is fully taxed.

2. If leave income is received from two or more companies in the same prior year, the total amount of tax-free leave salary cannot exceed Rs.25,000,000.

For e.g. if Mr. A utilized Rs 5,00,000 already at the time of earlier resignation so now he is only entitled to use balance exemption of Rs 20,00,000 for the exemption computation next time.

Tax Hack

We shouldn’t take any leave encashment during the service because it is fully taxable so it is always recommended to take leave encashment  at the time of retirement.

Conclusion: Leave encashment is a valuable aspect of an employee’s financial planning, offering a source of income at retirement. By understanding the rules, types of leaves, tax implications, and exemption criteria, individuals can make informed decisions to optimize their financial well-being.

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The above article is written by Ms. Shruthi Nyavanandi (shruthi.nyavanandi@abacussolutions.co.in) and reviewed by Mr. Suyash Tripathi (suyash.tripathi@abacussolutions.co.in)

Author Bio

Qualification: CA in Practice
Company: Suyash Tripathi & Co. Chartered Accountants
Location: MUMBAI, Maharashtra, India
Member Since: 18 May 2020 | Total Posts: 75
Mr. Suyash Tripathi is a member of the Institute of Chartered Accountants of India (ICAI). He has an experience in the fields of Income Tax, International Taxation, Company Law, Banking, Finance etc. He has been conducting Statutory & Tax audit, Internal audit of large & medium scale Limited View Full Profile

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