All About Leave Encashment: Taxation & Calculation

What is covered here

The concept of Leave Encashment:

Every salaried employee as per labour law is eligible to avail some Earned leaves during his/her working period and If he/she takes lesser leaves than they are eligible for, then they can encash the balance leaves either annually basis or at the time of leaving the company.

Calculation Method:

There is no standard rule of calculation of much leaves one can carry forward every year and how many leaves one can encash. Usually, employers have their own rules and basic salary and dearness allowance are taken into consideration for the calculation of the amount

How it is Taxed:

The taxation of leave encashment is dependent on the following factors:

Employment status i.e.

Government or
Private sector employee, or

Time of Encashment

During the employment
Upon Death
At the time of retirement

Important Points:
Leave encashment is only for completed years of service. If you have 10 years and 9 months of service, the calculation would be for 10 years only.
Government employees can have maximum of 10 months of leave accumulation and hence encashment
There is no statutory compulsion to have Leave Encashment Policy. So your employer may or may not have leave encashment at their discretion.

Leave encashment Received

During the employment:

It is fully taxable for both Government and Non-Government employee if encashed partially or fully during employment.

On Death:

It is tax-free when paid to the nominees or legal heirs at the death of an employee.

At the time of Retirement:

Government Employee:
- The entire amount received is tax-free
Non-Government Employee:
- As per section 10 (10AA) of income tax act its minimum of the following 4 factors:
- Amount received
- The maximum cap as stated by the Government – Rs 3 Lakhs
- Last 10 months average basic salary & dearness allowance before leaving the job
- Cash equivalent of the leave balance, subject to a maximum of 30 days for each completed year of service

Let’s understand it with an example.

Ram is a non-government employee who receives Rs 4.5 lakh as his leave encashment at the time of retirement. He worked here for 20 years and was eligible for 40 earned leaves every year. Below is the calculation:

No. of earned leaves Ram was eligible for = 20 X 40 = 800 days
He used 454 leaves during his service period
Leaves eligible for leave encashment = 800 – 454 = 346 days
Average last 10 months basic + dearness allowance = Rs 22,000

Tax Calculation:

The tax exemption would be the minimum of the following:
The amount received as – Rs 4.5 Lakhs
The maximum cap as stated by the government – Rs 3 Lakhs
Last 10 months average basic salary & dearness allowance before leaving the job – Rs 2,20,000 (Rs 22,000 X 10)
Cash equivalent of the leave balance, subject to a maximum of 30 days for each completed year of service – Rs 84,260 (Note 1)

Taxable component = Rs 4,50,000 – Rs 84,260 = Rs 3,65,470

Note 1.
Earned leave eligibility as per above rule = 30 days X 20 = 600 days
Availed Leaves = 454 days
Eligible Leaves encashment (as per rule) = 600 – 485 = 115 days (3.83 months)
Cash equivalent = 3.83 X 2200 = Rs 84,260
Tax exemption = Rs 84,260

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