What is Leave Encashment?

Leave Encashment means receiving money in exchange for the unused paid leaves that have been accumulated over the course of your service, provided by the employer. 

According to the labour law, every employee is given several paid leaves every year. It is not necessary that they have to use all of them, so in case there are some unused paid leaves left, they can either encash them at the end of the year or carry them forward to the next year. 

If the employee accumulates paid leave every year, they will be left with an invariable number of unused paid leaves at the time of their retirement or resignation. This compels the employer to provide compensation for all these unused paid leaves. This whole concept is known as leave encashment. 

Types of Leaves

According to the company's policy, various types of leaves are mentioned. They are distinct from company to company. Here are a few types of leaves that are generally available for the employees: 

1. Medical Leaves: If any employee is not able to perform their tasks in an organization due to their health conditions, then they should ask the employer for medical leave. There is a limit for the maximum medical leaves, and it varies from one company to another. 
2. Casual Leave: Employees can take casual leave for their personal reasons, and there are 7 to 10 days of leave available. The encashment of these leaves can be different from each other. 
3. Holiday Leaves: Holiday leaves are provided by the employers to their employees, and there is no salary deduction for them. The maximum number of these leaves that you can take is totally dependent on the firm and the employer.
4. Earned Leave or Privilege: The employees can use all these earned leaves by providing a prior notice to the authority. After a certain period of time, you will be able to encash these leaves. This policy can differ from one firm to another.
5. Maternity Leaves: These leaves are provided to the female employees, and they can last for 12 weeks to 26 weeks during the time of pregnancy. You can ask for the extension in case you need it, but there is no payment for these leaves. Maternity leave is not available for encashment. 
6. Sabbaticals: These leaves are taken by the employees to expand their knowledge and enhance their skills. They have to enrol for a particular course, and for that specific time period, their leaves will be reimbursed by the employer. 

Taxation of Leave Encashment

The leave encashment, which is received by the employee, is taxable. The tax implication on leave encashment depends on the time at which it happens. It can be received in two ways: 

Encashment of leaves during service

As an employee, if you get the leave encashment at the time of your service, then the amount is completely taxable and comes under the head " Income from Salary". Although there are some tax benefits that you can claim under section 89 of the Income Tax Act. You have to fill out the Form 10E on the official website of the Income Tax Portal to claim this tax relief. 

Encashment of leaves at the time of resignation or retirement

Different taxation rules apply to leave encashment at the time of retirement. Here are a few conditions under which you can claim a complete or partial exemption:

Leave Encashment Calculation

For the non-government employees, here is the formula for calculating the exemption on leave encashment:

*Salary is equal to basic salary, DA, and commission based on a fixed percentage of turnover.

**There is a fixed amount of Rs 25,00,000 allowed as the leave encashment exemption limit, no matter how many times an employee receives leave encashment from different employers. If an employee has used Rs 5,00,000 at his first resignation, then he can only use Rs 20,00,000 for the calculation of his next exemption. Hence, an employee is allowed the total exemption of Rs 25,00,000 for the encashed leaves from all the employers.

NOTE:

• If an employee had received leave encashment form more than one employer in the same previous year, then the maximum exemption amount is capped at Rs 25,00,000.
• The exemption u/s 10(10AA) is available for the assesse, no matter under which regime they pay their taxes. 

Example of Leave Encashment Exemption

Let's take an example to understand the leave encashment exemption in a better way: 

Mr. A is an employee, and he is retiring after 15 years of service. He was given 35 days of paid leave per annum from his organisation, that is, the total leave during his entire job period is 525 days. He has used his 200 paid leaves, and there are 325 unused leaves left. 

He was drawing a basic salary + Dearness allowance of Rs 33,000 per month at retirement. He received Rs 3,57,500 and encashed leaves calculated as 325 days * Rs 1,100 (per day salary).

Based on the policies of leave encashment and the salary of the employee, one can plan the taxes by determining whether they should encash their leaves every year or receive a lump sum amount at retirement or resignation. You should have a better understanding of inflation before planning taxes.