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Leave Encashment: Tax Exemption under 10(10AA) - Calculations & Formula

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Synopsis:

Leave encashment is a reliable retirement plan or a smart move to increase your income. With tax exemptions provided under section 10(10 AA) of the Income Tax Act, an employee can earn a valuable profit with their unused paid leaves. Let’s learn the process of leave encashment and a simple formula to calculate leave encashment.

Leave encashment is a reliable process that allows an employee (both government and private) to monetise their unused paid leaves. While there are varying policies for leave encashment, organisations provide this option as it benefits both the employee and employer. 

To calculate the amount you can get using your unpaid leave, multiply your unpaid leave days by your per-day salary. Section 10(10AA) of the Income Tax Act discusses leave encashment and the tax exemptions employees can enjoy.

In this article, we will talk about leave encashment formulas and rules that can help you design a reliable retirement plan.

What do you Understand about Leave Encashment?

As an employee, you are probably getting the option of paid leave. Providing paid leave to employees is a legal responsibility of an employer. However, have you ever wondered how to encash these leaves and create a savings fund for post-retirement life? Or what is leave encashment?

Leave encashment is the compensation awarded to you for the unused paid leaves. To simplify it- Paid leaves you don’t take can be compensated by your employer at your retirement or resignation. 

Private organisations have varying policies of offering leave encashment under which you can get compensation while working in the organisation, at the time of resigning or use the unpaid leaves in the next calendar year without taking any compensation. 

Leave encashment can be used to your benefit if you understand the concept better. Read on to find all the details on leave encashment. 

What are the Types of Leaves?

Organisations have a stipulated set of leaves that they provide to their employees which keeps varying. However, here’s a list of leaves that are mostly offered to employees:

  • Casual Leave

As the name suggests, casual leave is provided to an employee for personal reasons and around 7-12 days of casual leave is provided in one calendar year.

  • Medical Leave

Medical leave is a mandatory leave that an employer has to offer. However, the number of days keeps varying from one organisation to another.

  • Holiday Leave

Holiday leaves are a form of casual leave where in most organisations, no salary is deducted. The number of days again varies in different organisations. 

  • Maternity Leave

Providing maternity leave to female employees is mandatory as per the Maternity Benefit Act. 26 weeks are offered which can be taken in different slots as per the wish of the employee. 

  • Earned Leave

Earned leaves are also called privilege leave under which employees can go on leave without any salary deduction. The same can also be encashed in future if earned leaves are not used.

  • Sabbaticals

Sabbaticals are those leaves under which an employee can go on a long leave to upskill their education or prepare for competitive exams etc. Sabbaticals are not paid leaves but the employee has the option of joining back after the leave. 

Calculation of Leave Encashment

Paid leaves are offered to both government and private sector employees. Remember that a government sector employee gets a 100% tax exemption on the compensation of unused paid leaves or leave encashment.

For a private sector employee, the leave encashment is taxable. To calculate leave encashment you can use this simple formula:

Leave Encashment=(Basic Pay+Dearness Allowance)×Number of Unused Leave Days

Example of a Leave Encashment Exemption

Now that you know what is leave encashment and working of leave encashment, let’s take an example to help you understand better-

Assume the following:

  • Basic Pay = ₹30,000

  • Dearness Allowance (DA) = ₹10,000

  • Number of Unused Leave Days = 50

Using the formula:

Leave Encashment=(Basic Pay+Dearness Allowance)×Number of Unused Leave DaysLeave Encashment=(Basic Pay+Dearness Allowance)×Number of Unused Leave Days Leave Encashment=(₹30,000+₹10,000)×50 Leave Encashment=(₹30,000+₹10,000)×50 Leave Encashment=₹40,000×50 Leave Encashment=₹40,000×50 Leave Encashment=₹2,000,000Leave Encashment=₹2,000,000

So, the total leave encashment amount would be ₹2,000,000.

Please note that this is a simplified formula, and actual calculations may vary depending on company policies, additional allowances, and specific terms of employment.

Benefits of Leave Encashment

Leave encashment has multiple advantages for both employees and employers. Let’s take a closer look at the benefits of leave encashment to help you make an informed decision about your unpaid leaves:

  • Financial Flexibility

Leave encashment allows employees financial flexibility by monetising the unused paid leaves. In addition, some organisations provide the option of encashing unused paid leaves at a fresh calendar year that promises a bonus income. 

  • Better Work-Life Balance

Paid leaves are designed to offer work-life balance and with an option to encash unused leave, employees are at liberty to plan their work-life balance with a better perspective.

  • Retirement

Leave encashment is considered a reliable retirement plan. An employee can save up their unused paid leave and create a safe financial net for retirement. This is not a part of any pension scheme and therefore leave encashment on retirement works as a bonus income.

  • Tax Implications

A government employee gets a complete tax exemption on leave encashment. For private sector employees, leave encashment on retirement is eligible for tax exemptions under Section 10(10AA) of the Income Tax Act, up to a maximum limit of ₹25,00,000. There are no tax exemptions for leave encashment during the service or upon resignation

Conclusion

Leave encashment is a reliable and smart move to add a valuable asset to your retirement plan. Based on your salary and work tenure, the organisation you work at offers paid leave or earned leaves that you can monetise rather than taking leaves when it’s needed. While it is important to strike a work-life balance with personal leaves, you can choose your reasons for leave wisely to add a valuable amount for a reliable retirement plan. In addition to financial stability, there are tax exemptions provided that you must explore to use leave encashment to your benefit.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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Frequently Asked Questions

Can I use the entire limit of Rs.25,00,000 for leave encashment if I have availed of the exemption earlier?

Answer Field

No, ₹25,00,000 is the maximum limit that you can enjoy under tax exemption for leave encashment. If you have used any amount for exemption earlier, this amount will be reduced from ₹25,00,000 the next time.

Is leave encashment taxable on resignation?

Answer Field

Yes, the leave encashment taken by an employee at the time of resignation is taxable as “income from salary”.

What is the provision for leave encashment?

Answer Field

Leave encashment is a smart move used by employees to monetise their unused paid leaves. The amount earned from leave encashment comes under certain tax exemptions also as per section 10(10 AA) of the Income Tax Act.

How many leaves can be encashed?

Answer Field

Every paid leave that an employee has not used can be encashed. However, it is recommended to check the organisation’s Terms and Conditions of leave encashment.

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