Leave Encashment – How it is taxed in the hands of the Employee

In layman terms, Leave Encashment means to avail salary in lieu of accumulated leaves. In any organization, Leave Encashment is one of the major incentives for employees not to avail leaves :). I was one such employee who believed in the accumulation of leaves. In all my previous organizations, i accumulated at least 80% to 90% of the total leave eligibility. Normally the Leave Encashment policy of the organization allows you to encash the leave at basic salary.

If your salary structure is tax friendly i.e. fully loaded with perquisites and allowances. In such cases, basic salary is less than 50% of gross salary. Though it helps to save a considerable amount of income tax but leave encashment might not be financially beneficial in such cases. Another strategy to maximize financial gain is to opt for leave encashment only at the time of resignation or retirement. It has dual benefit i.e. you get substantial amount at the time of encashment. Secondly, during the service period, your basic salary keeps increasing thus you receive a higher payout.

Another advantage of leave accumulation is that you can adjust the leaves accumulated against the notice period. It is beneficial if you need early relieving. For example, in one of my previous organizations, my notice period was 90 days. Post-resignation, i was seeking relieving in 15 days i.e. i served 15 days notice. I had a leave balance of 62 days. Therefore, 62 days were adjusted against balance 75 days notice period. In effect, i paid for only 13 days notice period. Indirectly, i received the benefit of full salary on my leave balance :).

These days organizations are smarter than employees. They include provisions to compulsorily avail fixed no of leaves or put a cap on no of leaves that can be carried forward normally 10 or 15. It is projected as work-life balance initiative from HR perspective. Trust me the sole objective is to save cash payout/burn through leave encashment. As an employee, you can opt for leave encashment at following stages

(a) During the service

(b) At the time of Resignation

(c) Termination of Service

(d) At the time of Retirement

In case the employee resigned or service of an employee is terminated due to layoff and employee is not planning to take up employment. In such cases, (b), (c) and (d) can be referred as Retirement only (This is my personal interpretation). At the time of retirement, the tax treatment is different for Government and Private sector employees. Let’s check out.

Leave Encashment – How it is taxed in the hands of the Employee

1. Leave encashment during the service is fully taxable in the hands of an employee. Irrespective of the period of accumulation, it is taxed in the year of such encashment.

2. Leave encashment by the Govt employees at the time of retirement/superannuation is FULLY exempted from the tax. Here the definition of Govt employee includes both central govt and state govt employee.

3. Leave encashment by the Private sector employees at the time of retirement is calculated as per the following formula

The leave salary exemption will be least/minimum of the following four

A. Period of Earned Leaves in Months* X Average Monthly Salary**

B. Average Monthly Salary X 10 i.e. 10 times the Average Monthly Salary or 10 Month’s Average Salary

C. Max Amount as declared by the Central Government i.e. Rs 3,00,000 (It may be revised in future)

D.  Actual Leave Encashment received at the time of retirement

*How to calculate Period of Earned Leaves in Months

(i)  For calculation, You can only consider only the no. of completed years. For example, if my service is 23 years 8 months then for the purpose of calculation i can consider only 23 years. In this case, Period of Earned Leaves in Months will be 23 X 12 i.e. 276 Months.

(ii) Max capping on no of leaves entitlement per year is restricted to 30 days. For example, if during any particular year, no of leaves accumulated is more than 30 i.e. 35 then you can claim tax exemption only for max 30 days for that particular year. Though, actual leave encashment will be on 35 days. In the same example, as mentioned in point (i) assuming an employee accumulated 35 days every year for 23 years. In this case, he can claim the exemption only for 30 days per year.

(iii) Gross Total Leave in no of days will be (i) x (ii) i.e. 23 x 30 = 690 Days leave. Please note that this is Gross leave entitlement.

(iv) Assuming during my service period of 23 years, i availed 80 leaves and also encashed 60 leaves. Therefore, no of leaves encashed or availed during the period of service will be 140 days. The leave encashment amount for 60 days leave will be reduced from ceiling amount of 3L. I will explain it later in the post.

(v) Period of earned leave will be (iii) minus (iv) i.e. 690 – 140 = 540 Days.

(vi) Period of Earned Leaves in Months = (v) divided by 30 i.e. 540/30 = 18 Months.

** How to calculate average monthly salary

The average monthly salary of 10 months just preceding the date of retirement is considered as the average monthly salary. Normally the date of retirement is the last date of the month. Therefore, assuming i am retiring on 31st Dec 2016 then my average monthly salary will be an average of monthly salary from March 2016 to December 2016.

Here the definition of salary include

• Basic Salary
• DA (Dearness Allowance). Normally private sector employees don’t get DA
• Commission based on fixed % of turnover achieved by the employee.

Besides above mentioned three components you cannot include any perquisites, allowances or any other salary component for the calculation of average monthly salary.

Leave Encashment – Important Points to Remember

1. The calculations mentioned in the post are cumulative in nature. For example, if you worked with 4 different employers during the period of service then you cannot calculate tax exemption on leave encashment separately for each employer. The max exemption availed cannot exceed the ceiling of 3L as mentioned in point no 3(C). In other words, exemption of Rs 3,00,000 is a once in a lifetime leave encashment tax exemption.

2. The exemption availed during the period of service will be reduced from the ceiling amount. For example, in the example shared by me assuming i received Rs 75000 for encashment of 60 days leave during the period of service. In this case, at the time of retirement, my ceiling limit will be 2.25 L in point no 3 (C) i.e. Rs 3,00,000 – Rs 75,000.

3. The leave encashment exemption (as per calculation) should be reduced from the total leave salary received / actual leave encashment to find out taxable leave salary. Depending on the case to case basis, you might have to pay tax if the part of leave encashment is taxable.

4. Leaves adjusted against notice period are considered as leaves availed for calculation of leave encashment exemption.

5. Last but not the least, the leave encashment is taxed as per the respective tax slab of the taxpayer in the corresponding financial year. For example, if i received leave salary of 8L accumulated from FY 2008-09 to FY 2015-16 in the FY 2016-17. Assuming, out of 8L the leave salary of 6L is taxable. In this case, 6L will be taxed in FY 2016-17 as per my income tax slab for FY 2016-17.

Summary:

To summarize leave encashment during the period of service is fully taxable for both government and private sector employees. Though, Relief can be availed u/s 89. At the time of retirement, the leave encashment is fully exempted for Govt employees and is partially/fully exempted for private sector employees depending on the case to case basis.

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